When Economists Being Wrong Changes The Time Risk Of Lending And, Therefore, Mortgage Rates

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For as much as we talk about expectations, it never hurts to review the rule of why mortgage rates go up every time that economists get surprised:

Banks rely on economists as much as you do.

When the "experts" are wrong, or when they make bad predictions about the economy, everybody has to recoup from the damage. 

Think of it like a giant game of Don't Tip The Waiter.  If every piece is right on the middle, balance is never a problem and every player is safe.  Only when too many pieces are outliers on the edges does the whole game swerve wildly.

People sometimes forget that the investment horizon of a bank differs from the investment horizon of its customers.  Banks think in terms of days (or weeks) for their investments; customers think in years. 

Because banks focus on very short-term investments, they need to be careful when lending to a person for a relatively long period of time like 3 year, or 30 years, or longer.

The bank's biggest risk in tying up money long-term isn't the homeowner's default risk, but the risk of time.  Time is a great unknown and can changes the value of money. 

We have all heard the "candy used to cost a penny" bit from our folks.  Well, how about this one: "Gas used to cost $1.49 per gallon".

As life and living gets more expensive, banks want to protect themselves from the rising costs so if a bank thinks that money is going to be worth less in the future, it will raise your interest rate today to compensate for that loss. 

This is one of the reasons why ARMs tend to have lower rates than fixed mortgages.  With ARMs, you agree to share the time risk with the bank and, in return, the bank agrees to lower your cost of borrowing.

Now, let's wrap this all up in a nice little bow and get back to the economists ruining your day. 

Because banks rely on economists to make their risk projections, when economists under-project how the economy performs, the banks react by raising mortgage interest rates to cover themselves against time and their new projections of time risk.

This week, economists have been really wrong and, as a result, the waiter is about to tip.