Banking Profits And A Double Dip Recession - Low Rates Now Are Going To Create a Second Crisis
If you’ve been looking at the newswires you’d see that apparently in six short months the whole banking sector is turning itself around. Everyone is showing a profit and traders are anticipating an excellent dose of first quarter profits from this nation’s bailed out banks. But there are serious consequences for short term prosperity, we’re setting ourselves up for a nasty double-dip bottom.
Right now rates are low, real low, actually they’re the lowest they’ve ever been. Bankrate.com shows 30 year mortgages for 4.98%. Couple that with the $8000 homebuyer tax credit and there are literally droves of people either buying their first home in years, or refinancing at a lower rate.
Let’s discuss Refi’s.
Banks love people who refinance, especially when they come from another bank. Refinancing is essentially borrowing at a lower rate to pay off a higher rate loan. For example if you purchased a home a couple years ago, and refinanced now, you’d probably be able to borrow for 1-2% less.
When people refinance their loans the banks also get a hefty cash payout for selling the loan. The loan is packaged into mortgage-backed securities then sold off to another bank or broker for sale on the open exchange. Either way, banks like closing on loans, its money in their back pocket.
Refinancing though may come back to bite!
At current interest rates banks are going to take a hefty cut on their operating margins. Credit is cheap but capital is expensive and many banks will be refinancing their own loans at a lower rate, effectively trading less income to keep a customer or to prevent said customer from going to the bank down the street.
One important factor in all of this refinancing madness is the ability to sell the loans. Interest rates are not going to stay sub 5% for long, and I would expect that 6% interest rates are already on the horizon. Inflation is going to be a concern soon and rates are going to rise.
So what happens when rates rise? Prices fall!
Mortgage-backed securities are essentially bonds and trade all the same. When investors begin to demand higher returns for loans, the value of the mortgage will plummet. Yield up, price down. This is where mark-to-market comes into play.
Consider holding a portfolio of loans worth $1 Million at a 5% rate. Should interest rates rocket to 8%, your portfolio of mortgages is now worth only $625,000 at market value. Thats a paper loss of $375,000 that will only be recouped if mortgage owners HOLD the mortgage until the full balance is paid. Otherwise, investors take an immediate loss.
If you thought this credit crisis was bad, just wait until rates rise and all of these new home loans are sold off. Investors are willing to accept 4-5% returns right now, but they won’t be for much longer, and we should all expect much larger losses in the banking industry in the future.
Jordan, you are on track. All the excitement is setting up many investors for another fall. The bear market is not over yet. I recently wrote an article on just that here http://tinyurl.com/dkqrfw