How the Credit Crisis Will Impact Your Interest Rate

The sub-prime crisis and the credit crunch are about the failure of a lending system creating by Wall Street. Instead of banks keeping loans on their balance sheets, they pooled them and sold them off in the form of bonds and other securitized investments. Banks can only lend based on the amount of equity (deposits, cash, etc.) they have on their balance sheet. By removing the loans from their balance sheet, they created more space to do more lending. This phenomena has ended.

The sub-prime crisis and the credit crunch are fundamentally about the failure of a lending system created by Wall Street. Instead of banks keeping loans on their balance sheets, they pooled them and sold them off in the form of bonds and other securitized investments.

Banks can only lend based on the amount of equity (deposits, cash, etc.) they have on their balance sheet. This is regulated and they must adhere to these ratios or risk being closed down or fined by their respective government agency or central bank. By removing the loans from their balance sheet via securitization, they created more space to do more lending. One way to look at it is like a garage. You can only fit so much in your garage. But if people come and take things out, you can keep filling it up.

Securitization is dead. Numerous articles are being written about it as we speak. What does that mean? Banks will have to go back to on-balance sheet lending. They won't be able to bundle their loans and get rid of them. This means their garage will fill up much quicker. Once a garage is full, banks can either stop lending, or expand the garage.

But to expand their garage, they will need more capital. Capital from most banks comes from depositors, shareholders, investors, etc.

The Implication for Depositors

There will be a huge demand for deposit dollars. As banks bring loans back onto their balance sheets, they are going to need deposit dollars to support those loans and deposits are among the cheapest ways to get them. Look for banks to start increasing the rates they pay, especially for longer-duration CDs.

The Implication for Borrowers

It will become harder to get a loan, mortgage, home equity, credit card, etc. Before, banks could hand out money almost free. They weren't as concerned about the quality of the lender because they weren't holding the loan. Now they will. They'll also have less money to lend. Tighter standards and less money will mean higher rates. Look for higher rates on almost every type of loan product.

It will be awhile before the full implication of the credit crunch becomes known but it appears that the recent way of doing business is over.

Sam Cass
Sam Cass: Sam Cass, MBA, JD, University of Texas at Austin. Always a fan of Leonardo Da Vinci.

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Comments

  • ktexas

    January 31, 2008

    Seems like for the past few years, there hasn't been much yield difference between the short and long term CDs. Perhaps this will finally change.

  • Sam Cass

    January 31, 2008

    It should change it. Long term money was cheap because of securitization. Banks were floating in a bubble of liquidity. That's all changed. We'll see what happens to rates.

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