Low Interest Rate Long Term Effect

"The prolonged low-interest rate environment is transforming the banking industry from savings and loans to service and loans," said Dan Geller, executive vice president of research firm Market Rates Insight in San Anselmo, Calif. (Fitzpatrick) Consumers may think that the continued low interest rates are a profound thing, but banks on the other hand think much differently. Consumers are refinancing their houses at rates as low as 2. 875%, while big banks like Hudson City Bancorp Inc., a mortgage lender, are being forced to sell themselves to M&T Bank Corp.

These super low interest rates are complicating the industry’s journey to a recovery from the financial crisis. In the article” Low Rates Pummel Banks”, from the Wall Street Journal, Dan Fitzpatrick further explains the negative effect of long term low interest rates. Fitzpatrick describes it as “Borrowers Benefit, but Industry Lending Profits Hit Lowest Level in Three Years”. (Fitzpatrick) Usually, we would believe it to be true that lower interest rates are a good thing, because they make it cheaper to borrow. Like so, there are those in support of the lower rates for example, the Fed and the consumers.

For the past four years, since the 2008 financial crisis, the Federal Reserve Board had been trying to bounce back the US economy. The short term interest rates are extremely low and by purchasing more bonds they are reducing long-term rates. In all this has lowered the Ten-year U. S Treasury yields to 1. 43%, the lowest since World War II. (Fitzpatrick) The Feds see this as a positive because they believe the low rates increase the economic growth along with employment. They support their belief by stating that the low rates make it easier and cheaper for companies and individuals to borrow money.

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These low rates developed, in part due to the Fed, have sprung a rush in the mortgage refinancing industry. The growth in mortgage refinancing has assisted fee revenue at two major companies, J. P. Morgan Chase & Co. and Wells Fargo & Co. , which control nearly half of the mortgage market. Wells Fargo decided to keep nearly $10 billion of residential mortgages, which they would normally sell to investors just in search of more yield. Fitzpatrick speaks of a woman in N. Y. , Katherine Karl, which was able to refinance her house at 2. 875%, who expresses that her desire to refinance was because of the istoric low of interest rates. Many others like Karl have also taken opportunities to refinance their homes. Although those companies have survived, and Karl lowered her rate by 2. 5 percentage points, not all are seeing such positive effects. In an article by Robin Sidel of the Wall Street Journal, “Regional Bank Lands Big-City Deal”, we can see the downside of these low interest rates. (Sidel) Hudson City, a mortgage lender based in Parmus, N. J. , has 135 branches, and has assets of $43. 6 billion, decided to sell itself to M&T Bank Corp. , which is a regional bank.

Hudson City’s loan portfolio was largely focused in mortgages, due to the drop in interest rates and the refinancing, the value of the portfolio dropped along with the interest rates. Once Hudson City had started to see a devalue of their portfolio, they had considered transforming themselves into a commercial lender. However, after much thought the Chief Executive Ronald Hermance decided this would take too long and increase their staff tremendously. (Sidel) This then led to the selling of Hudson City to M&T Bank Corp. If interest rates remain low we can expect to see more mergers and smaller banks selling out.

In Chapter 5 of the book, there is an application called “Explaining Low Japanese Interest Rates”, which can help better understand the negative effect of low interest rates. In the 1990s and early 2000s, Japanese interest rates became the lowest in the world, in November of 1998, the interest rate on Japanese six-month Treasury bills actually turned negative. In correlation with the extremely low interest rates was a prolonged recession, which was followed with deflation. As we learned in the book, the negative inflation causes an increase in the demand for bonds, because of the decrease in expected return on real assets.

This in turn caused the demand curve to shift to the right. The negative inflation also raised the real interest rate, thereby causing the supply of bonds to adjust, moving the supply curve to the left. In the end this led to an increase in the bond price and a decrease of interest rates. In the book it explains to us that the interest rate is negatively related to the bond price. In other words, when the equilibrium bond price rises, the equilibrium interest rate falls and vise-versa. There are other factors which led to the down fall of interest rates in the Japanese market.

For example, the lack of profitable investments opportunities in Japan, and the business cycle contraction and the decrease of wealth during the business cycle contractions. These all would lead to the increase in bond price and the decrease of interest rates. This application shows us that low interest rates are not a good thing. In Japan’s case, the low and negative interest rates were a sign that their economy was in trouble with falling prices and a contracting economy. The interest will only rise back to normal levels when their economy returns to a better economy.

Fitzpatrick goes on to explain that because of the low interest rates banks will have to consider new ways to make money like Hudson City considered, by offering other services. However, higher cost of those banking services could lead to losing customers in the financial world which would then in return have a negative effect. He predicts that “Over time, subdues bank profits are likely to accelerate a shakeout that has halved the number of insured institutions over the past two decades”. (Fitzpatrick) He states this will happen by the pressure for smaller banks to take advantage of new technologies.

The banks are suffering from the low interest rates in more ways than one. The low interest rates affect the bank’s benefit of holding depositors’ cash at the low rates. The problem with this is that many banks are stuck with a large increase in money to invest during which returns on securities are decreased. These deposit rates are at their lowest since the 50’s. (Fitzpatrick) Another way banks are suffering is due to the fact that they bet on higher-yielding mortgage bonds before rates fall. To counteract their losses banks are increasing loan prices.

They are doing this in hopes of regaining their losses from the low interest rates, or refinancing of mortgages. In conclusion, although the low interest rates show a profit for some, the long term effect of low interest rates is bad for us. The low interest rates are a sign that are economy is in trouble, opposite of what the Fed is trying, just as in Japan. For our economy to return to a healthy economy, the interest rates will need to return to a normal level. Many banks will be forced to merger or sell out. Other banks will be forced to create new services. There will be an increased cost in the banking system, by increasing loan prices.

The financial crisis and the Fed attempt to strengthen the economy have proven to be the derivative of the low interest rates which is driving the banking system, and mortgage lenders into chaos. Fitzpatrick describes it perfectly by quoting Mr. Lied saying Many smaller banks will "throw in the towel" and sell, as Hudson City did, if low rates persist, Mr. Lied said. "There are no magic bullets and there is no easy answer. "

Works Cited

1. Fitzpatrick, Dan. "Low Rates Pummel Banks. " Wall Street Journal 23 October 2012: A1.
2. Sidel, Robin. "Regional Bank Lands Big-City Deal. " Wall Street Journal 28 August 2012: C1.

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