Who Really Sets Interest Rates?

On today’s show we’re going to break down the lending market into its constituent components and examine each of them independently.

The lender is the loan originator who underwrites the loan. The loan servicer is the one who collects the interest. The Investor set an interest rate at which they’re willing to lend money and its up to the loan originator to find a borrower with the correct risk profile that meets the risk tolerance of the investor.

Investors in the bond market are also lenders. So when a bank lends money to a borrower, they have to be mindful of the bond buyer who is ultimately going to securitize the debt.

Back in the old days, banks would take in deposits and depending on the amount held in deposit, the bank would lend accordingly.

Over the past 20 years, we’ve seen an increasing amount of shadow banking. This is where banks sell their debt in bond offerings to the commercial mortgage backed securities market. This takes those loans off the bank’s balance sheet and allows the bank to originate more loans.

Banks make money on the differential between the interest collected on their loan portfolio and the interest paid to depositors, multiplied by the bank’s leverage. So for example if a bank charges 5% interest, and they pay 1% interest to their depositors, they collect 5% interest, multiplied by the bank leverage. If they must maintain 10% in reserve, then they collect 9 x 5% = 45%, and they pay out 1%, for a net profit of 44% of the funds on deposit. ‘

It sounds like a good gig and it is.

But the banks ultimately want to get these loans off their balance sheet so they can originate more loans. Why? Because banks get paid an origination fee, in addition to the interest rate. If they sign a 30 year loan, then those funds don’t become available for lending again until the loan matures. That means the bank gets to collect their origination fee once every 30 years. But if they sell the loan into a secondary market, they can put that exact same money to work again and collect a new origination fee in addition to the interest on the loan.

Private lenders are different from banks in that they don’t have leverage. They can only lend out money that they have in their immediate possession. These lenders lend to private equity firms, private mortgage investment corporations, and they purchase bonds.

Private loan originators want to keep their loans recirculating as well. The originator gets to keep the origination fee, and the loan interest gets paid to the investors in the mortgage fund. If the loan term is too long, then the originator stops collecting fees and eventually goes out of business. So private lenders like the shorter loan terms to they can continue collecting fees.

Here too, the interest rate is determined by the risk premium that is being attached to the borrower by the lender.

I believe we are about to experience another liquidity crisis in the US and elsewhere in the world. If you are unconvinced, then ask yourself this simple question. If the currency is being devalued at a rate of 8.6% per year, would you be willing to lend money to a borrower at 5%? No? How about 6%? How about 7%? Still no?

How high would interest rates need to be for you to lend funds to a low risk borrower on a low risk project?

You have probably figured out by now that the private lenders and investors are in search of higher yield in order to compensate for the high rate of inflation. So if private lenders are not injecting liquidity into the market, then the only lender left is the lender of last resort and that is the central bank.