It is widely known that the Federal Reserve has been raising interest rates for some time with the intention of bringing down inflation. While the Fed has two official mandates of price stability and controlled inflation, that has not been the case for the past two years
So, what effect does this have on lending and credit?
To put it metaphorically, the Fed’s actions are like putting a dam on a mighty and fast-flowing stream that has been running for a decade. For years, especially over the COVID period, interest rates were historically low. But now, with elevated rates, we have seen more expensive and harder-to-obtain credit. Whether it is a commercial building development, a first-time home buyer, or a business seeking a line of credit, the “dam” is starting to dry the market.
Banks are originating fewer and fewer loans and mortgage-backed securities. With higher fees and high monthly payments, their underwriting has become more stringent, in addition to the fact that most borrowers would not be able to afford these high-rate loans. Originations throughout Q1 and Q2 were on pace to be 50% of 2022 levels. ($716 billion Q1 and Q2 2023 vs $1.6 trillion Q1 and Q2 2022).
Slower economic growth, rising unemployment, high inflation, and interest rates all drag on new construction and investments. Consumers are not the only party affected. Builders are less likely to build with these rising costs. Slowing demand could lead to softer pricing, also if consumer savings stay on the decline.
A number to watch shortly: the percentage of new subprime borrowers (sub-620 credit score). Recently, that number has only been around 3%, compared to 13% leading up to the Great Financial Crisis. This number will show if lenders are trying to drum up more business by extending credit to borrowers they previously would not have lent to. This is a major red flag; lower credit-worthy consumers obtaining more loans raises the bank’s risk. This is because these borrowers have a higher likelihood of defaulting on their mortgage payments based on their credit, income abilities, and repayment history. If this happens, then the bank will foreclose and be forced to take the property onto their books.
With credit tightening and becoming more costly, there will be a direct negative impact on the average and institutional borrowers’ bottom line in the near future.
Now I ask two questions: who does this affect the most? How much of an impact will the Fed halting rate hikes play soon?
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