The Fed Cannot Fix — Rising Location-Risk Rate Premiums

I’ve made this story way too complicated. Simply put, in the future banks will say, “Wait, you want to buy a property where!? That loan will cost 2% more”

In the next 12 months, my brother believes 30-year mortgages won’t go above 6.5%. I believe they’ll blow by 7% and become double-digit love-me-nots.

After a couple of rate increases, he believes the Fed will have to lower rates as the economy crashes.

My brother isn’t alone. Many believe the Fed steers the economy. Many believe the President creates jobs. I believe neither. The Fed only influences when we notice changes in credit.

I believe we are about to experience changes to credit that the Fed cannot change back. So called exogenous factors.

We shall see.

Contrary to popular opinion, the economy and interest rates are not connected like a playground seesaw.

For example, there are one-way factors that influence interest rates, like increased neighborhood vandalism. Such increases don’t work in the reverse. That is, lowering mortgage rates does not decrease vandalism.

When the Fed raises or lowers interest rates do they change the safety of a neighborhood? I don’t believe they do. What about the safety of American factories overseas? How can the Fed possibly effect that?

If Fed policy can’t change the location-risk of real estate what would happen to interest rates IF property owners, on the whole, have to pay for more security and maintenance?

For a variety of reasons — from greater income inequality to climate change disruptions — I believe location-risk will increase rates. This risk is growing both locally and globally.

Exogenous risk factors will add interest premiums to many loans in the decades ahead, thereby raising the average rate of interest for all debt.

None of this will happen quickly. In a sense I am only arguing that interest rates will go back to historical norms where security risk is an important component of loan rates.

As the recession progresses, it will be difficult to calculate just what those location (security) risk-premiums will be. Therefore, lenders will increase rates higher than they probably need to, just to be safe. They will keep doing this until there is enough data (loan experience) to reduce location-risk premiums.

As they do this, the Fed must follow.

Again, location-risk is just one aspect that effects interest rates. There are many others which the Fed cannot manage away.