mellicious: pink manicure (no direction)
[personal profile] mellicious
See here for what I'm talking about.

My question: I always assumed that the bottom of the credit market was just zero. Is it really possible (in the real world rather than just in theory) to have negative interest rates? Wouldn't that mean that the lender gives you money and pays you extra money just for taking it? I don't see why anybody would do that!

I have to admit that I don't exactly understand what's going on with credit right now anyway - isn't credit supposed to be tight? Wouldn't that mean that interest rates are higher rather than lower? I know everything is very volatile right now and that's part of the answer, not to mention just that this is a very complex subject, but if anybody has a relatively simple explanation I'd love to hear it.

Date: 2008-12-17 11:00 pm (UTC)
From: [identity profile]
When the market was high and the US dollar was strong, people that couldn't afford mortgage loans were given loans with extremely high interest rates. The values of their homes went up over time. When they could not pay the mortgage due to the exhorbitant interest rate, the bank took the house, and sold it again (for the increased value of the home), basically making money off the house twice. This worked fine when there were plenty of buyers to acquire these houses.

Once there was a bit of a recession, people stopped re-buying these houses, as they themselves could not afford their now ballooning 'adjustable' rates, which were adjusting because of the afore mentioned subprimers not being able to cover the banks losses.

Large lending companies had huge portfolios of these types of loans on their books, thus, when this collapsed, they lost much of their potential in earnings and assets, and could not hold themselves up. All of the major lenders are now holding companies or have been purchased by holding companies, which have other means of income to help secure the other areas of their companies. With that, the banks aren't lending each other money, so the banks have less money to lend consumers and businesses - hence it's hard to get a loan.

Does that make sense?

NPR had a great description of it using numbers like $100, $200, etc. that I'm still looking for...

Date: 2008-12-18 02:42 pm (UTC)
From: [identity profile]
Credit is tight right now because banks aren't lending, either because they don't have cash (liquidity problems) or because they are hoarding cash (i.e., expecting deflation). In the normal scenario, a dollar today is worth more than a dollar tomorrow. That's why when you give a dollar to your bank, or the bank lends you a dollar to buy a house, car, HDTV, etc., the recipient of the dollar pays interest. You're right that interest rates are governed in part by demand, but also by perceived risk (secured lending, like a mortgage, is less risky than unsecured lending, like credit cards, which is why mortgage rates are in the 5 to 6 percent range and credit cards are 18 percent plus).

But that scenario gets stood on its head on the rare occasions where there is deflation, which means goods and services increasingly cost less as suppliers lower prices to spur demand. In that case, a dollar tomorrow is worth more than a dollar today. Deflation is disasterous for an economy because companies stop making products, go out of business, fire employees, lower wages, reduce buying power further, creating recession, depression, doom.

The Fed has lowered *its* interest rate to zero or nearly zero to encourage banks to borrow money, the theory that the banks, being flush with cash, will now lend to businesses and individuals, spurring buying and expansion and, yes, inflation.

The back-up plan is not to give negative interest rates, but to print money, which has the same effect. Ben Bernanke once joked about dropping bundles of cash from helicopters. That's what Treasury will do if zero interest loans don't stop the deflationary cycle. Printing money has the effect of devaluing the dollar and raising prices (in gross terms, imagine everyone being given 10 percent of whatever cash they have on hand; they'd be able to spend 10 percent more on anything they wanted).

It's not an optimal solution because it will drive the value of the dollar down against foreign currencies making imports more expensive and hurting our trade balance, but it would also make our exports less expensive, and at the end of the day, anything is better than prolonged deflation.

Hope that is both understandable and helpful.


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