Finance and Stuff

Thoughts on finance and other stuff by Johan Lindén

Tag: mortgage rates

The Skewed Risk-Reward Ratio

skewed risk reward ratioTo illustrate the problem of how skewed the risk-reward ratio of banks vs. consumers is you just have to look at today’s all time high in the yield gap between banks’ mortgage rates and the rates banks borrow from the central bank.

This increased yield gap will increase bank profits while at the same time increase the interest burden to the consumer side of the equation. As usual, the banks score another goal on the behalf of the consumers.

So, is it really a problem in a free market that one party wants increased compensation for the increased risk? No.

Unfortunately there is still no such thing as a free market, and it is highly doubtful that the banks should get compensation for increased risk, knowing that the public will take the fall in the event of a default situation.

That is a really skewed risk to reward ratio for banks and consumers, where the consumers have drawn the short straw. This is also referred to as asymmetric risk, which risk expert Nassim Taleb, among others, often warns about.

I do not know which word to choose, laughable or pathetic, when the new president of ECB, Mario Draghi, today said:

“Therefore […] banks should consider restraining dividends and ad hoc compensation to strengthen buffers.”

Please Draghi, if you want some respect, do not use the word “should” nor “consider” in when speaking about economics.

Free markets will always end up doing the right choices, but regulated markets are in the hand of a few politicians armed with only hypothesis in one of the most complex field of sciences called economics.

Note:
I have had some technical difficulties and have not been able to update the blog frequently the last few weeks, but problems are resolved and I am back and track.

Fixed or Adjustable Mortgage Rate

Two questions regarding mortgage (home) loans.
Why are most people having adjustable mortgage rates on their home loans?
Is it better to have adjustable or fixed rate?

There are mainly two reasons why people choose adjustable mortgage rate:

  1. Because, an adjustable rate is mainly lower, since you have to pay an insurance premium for knowing your rate beforehand and will not end up with negative (or positive) surprises. You have secured your price of living at a certain rate. Secondly;
  2. since rates have steadily gone down for the last fifteen year or so, the bet to secure at a higher rate have been a losing bet. And since most home buyers memory have only seen interests going down and house prices going up, this is what they will define as a normal state of things.

The typical home buyer do now have the knowledge or understanding that interest rates have been much higher historically and most were not thinking of rates when rates were 15%, just back in the 90’s.

Another misconception is that they will be able to change to a fixed rate later on if rates go up. No such luck. If rates are going up, they will not be able to fix their rate at todays low level. They must then fix it at a higher level or continue speculating that rates will remain low, thus ruining the whole idea about keeping the cost of living low and decrease risk. What all this basically means is that when choosing an adjustable rate you are speculating with your home as security that rates will go down or remain neutral.

When choosing a time-period, do not choose 2 or 3 years, since then you are only insured from spiking interest rates for that period. Choose a period for as long as you need to make payments for the house, thus knowing your cost of living for that period instead of running the risk of ugly surprises. The government will not bail you out. They only do that to the really big and stupid risk-takers that have million-dollar-bonuses every year.

When choosing a fixed mortgage rate today, you get the lowest fixed rates in the history of mankind, and pay the smallest premium ever compared to the adjustable rate. So instead of taking the risk to double the cost of your living, fixing your rate seems like a pretty good deal of you ask me.

Below a chart comparing the long 30-year-old rate (blue) and the short prime rate (orange).

adjustable fixed mortgage rate home loan

Reproduced with the permission of Mortgage-X.com

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