Will We Commit Sins of the Past?

Today is August 1st and equity markets are surging. The Dow is eclipsing 15,630, up 0.87%, the S&P 500 has pierced 1,706, up 1.20%, and the Russell 2000 continues to outperform, up 1.30% to 1,058. The financial press is reporting the rise is due to good economic data abroad (read: China) and domestic (read: fewer jobless claims than anticipated). This is all subterfuge for the real reason: it's the first of the month and funds are buying, plain and simple. However, the dark side to all of this are rising interest rates. The 10-year treasury touched 2.70%, up 12 basis points, or 4.28%. This is important to note because consumer rates are driven by the 10-year treasury, such as mortgage rates. This brings us to the point of todays missive: what happens when rates rise enough to stifle the real estate market and lending markets?

Rising Mortgage Rates, Declining Standards?

The rise in interest rates has already taken a toll on the refinance market. Applications for refinance loans  are down significantly from just 6 weeks ago. Applications overall are down, which includes purchase loans. As mortgage rates continue to rise, refinance loans make less sense to homeowners and the cost to buy a home becomes less affordable to prospective homebuyers forcing them to pursue a cheaper home or declining to buy entirely. And what of the effect on lenders and financial institutions? Banking analysts are cheering a steepening yield curve but what about lost revenues from less lending? It's likely that there will be a trade off between the two and initially revenues will probably dip before lending reasserts itself. But how can that happen with rates rising? Who will these borrowers be and what will be their motives for taking out a higher rate loan? The short answer: borrowers who qualify under lower lending standards which is the inevitable outcome in the lending industry. Already some lenders are lowering their guidelines for loans. It can take the form of more flexible loan products, such as a higher loan-to-value allowance and or lower underwriting guidelines such as lower credit scores. All of these things add up to making loans more available to more borrowers to keep generating loan business. This process is inevitable and it's already happening. When one lender starts the easing process the rest are sure to follow. The ultimate result is a weakening of the industry and future problems down the road.

Are We Destined to Make the Same Mistakes and Face the Same Problems?

Yes.

Here's why: Pressure. The system from the top down is predicated on making money. The tightening lending standards are a reaction to an event (financial debacle or similar). As soon as enough time has passed and the market has healed itself, the fear of making bad loans is far outweighed by the fear of not making money. The more flexible lending standards and more exotic credit products are justified by a healthier economy and in this case, real estate market. And so the cycle repeats itself as the market inevitably heals itself  and allows itself to expand and grow. And it works for a while and the industry thrives until the next calamity. By the way, what is the "system" referred to above? The system is our way of life, the financial markets and the structure put in place to support it (legal, governmental, etc.). Although the tone here seems somber and apocalyptic, it is not. To the contrary, these are just observations of what are natural events happening given a set of circumstances. This is not a condemnation of the system or how it behaves. In fact, it would be unusual if things did not unfold the way that they do.