Rates Don't Matter--Liquidity Matters

February 3, 2015

The cure for systemic fragility is not low interest rates forever--it's a market that transparently prices credit and risk for lenders and borrowers, qualified and marginal alike.

One of the most unquestioned narratives out there is that the Federal Reserve raising interest rates from 0% to .25% (or .50%) will crush everything and everybody. But does this make sense? Let's start by putting ourselves in the shoes of actual lenders and borrowers.

From the point of view of the lender, higher rates are positive, as they enable higher margins. Perversely, the Fed's zero-interest rate policy (ZIRP) was negative for lenders, as the yields on issuing loans declined. This made legitimate lenders reluctant to issue loans, especially to those with less-than-sterling credit. Why take a chance for pitiful yields?

From the perspective of borrowers, another half-percent of interest is not a dealer breaker for most borrowers--what matters more than the interest rate is the availability of reasonably priced credit. What matters more than the advertised rate on a mortgage is the availability of mortgage money in the real world.

Low rates don't mean anything if borrowers can't actually obtain loans in the real world.

If I only qualify for a mortgage at 3.5% annual interest and a jump to 4% pushes me out of qualifying, I probably have no business buying the house in the first place.

Subprime borrowers, shackled to the debt-serf oars of 24% annual interest for auto loans and credit cards, will not be impacted by a notch up in the Fed rate; they are already paying the maximum rate.

Investment Riches Built on Subprime Auto Loans to Poor: 23.74% interest to buy a used car (via Joel M.).

If I'm running a business that needs to borrow money short-term for working capital, I don't care much if rates click up .50%--what matters to me is liquidity--that I can get the money I need with a phone call or email, and roll over my existing short-term debt easily.

What matters is liquidity, not the rate of interest. With rates at historic lows, any increase in rates has a modest impact on qualified borrowers. If a half-percent increase in interest kills a deal, it was a deal that should have been killed anyway, because it was too marginal to be a sound deal.

Yes, higher rates will be bad for those owning bonds, as higher rates depreciate the market value of low-yield bonds. But higher rates will be positive for lenders and minimal-impact for qualified borrowers as long as there is plenty of liquidity to grease new loans.

What we should be worrying about is not a click up in interest rates, but systemic liquidity. If the Fed maintains liquidity, the adjustment to higher rates will be modest for everyone but those who are so marginal that they shouldn't be issuing/taking loans in the first place.

If the U.S. economy is now dependent on marginal lenders and borrowers, then it is exceedingly fragile. The cure for systemic fragility is not low interest rates forever--it's a market that transparently prices credit and risk for lenders and borrowers, qualified and marginal alike.

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