Interest Rates, Mortgages, and Banking Stability: A Complex Connection

As consumers, we like the ability to lend short while borrowing long. What this means is that we like to make loans, or rather deposits, that we can withdraw on demand while also receiving loans (automobile loans, mortgages, etc) that are paid back on a schedule. Depositing and borrowing are both economic transactions and every transaction requires two parties. We call the institutions that specialize in this other side of the transaction “banks”.

We will mention a bit of history for concreteness. Once upon a time, gold was used as money. However, gold is inconvenient for most transactions. Banks would hold gold in a vault and issue paper money to depositors. This paper money bore the name of the bank. When a customer came in requesting a loan, the loan would also be made in the bank’s own paper. The critical point is that the total value of the paper circulating under the bank’s name exceeded the quantity of gold in the vault. This is called “fractional reserve banking”. Now, since a bank pays interest to fixed group depositors but earns interest payments from the loans it makes, it is natural to ask: What constrains the bank’s ability to make loans? The answer is that the public only demands to hold a certain quantity of the bank’s paper money. Imagine there are two banks in town: East Bank and West Bank. East Bank makes a loan to a contractor for a construction project in East Bank notes. The contractor pays for the work in these notes, some of which then go to customers of West Bank. The West Bank customers bring the East Bank notes to West Bank and deposit them. Now, West Bank holds East Bank notes which it does not want. It exchanges these notes with East Bank for gold. Thus, the gold reserve of East Bank falls.

What this means is that if East Bank prints more money than the public demands to hold, other banks will claim that amount of its gold. If it prints so much money that the value of the excess equals or exceeds the quantity of gold in its vault, the bank will fail. Thus, the threat of failure limits the ability of banks to lend.

This historical example is valuable for its concreteness. To understand the situation today, replace the gold with the cash the bank holds in its vault as well as the balance of the account each bank holds with the Federal Reserve and replace the paper money with the electronic money credited to your account. Further, the Federal Reserve now requires the bank to hold a certain percentage of its liabilities in reserve. This is called the reserve requirement.

Any fractional reserve bank can, at least in principle, experience a bank run. Such occurs when the total desired withdrawn deposits exceed the bank’s reserve. In this case, we refer to a bank as illiquid. This does not mean that depositors necessarily lose their money. Banks also hold assets as a capital buffer. When the bank needs cash and is unable to borrow it, it can sell these assets. Now, the total deposits make up the bank’s liabilities. If the sum of the bank’s reserve and its assets fall below the bank’s liabilities, we then call the bank insolvent.

It is common for banks to hold US Treasury bonds for assets. If a bank requires additional reserves, it can sell these bonds. Now, in an apparent segue, we must briefly discuss inflation. Since no one wishes to lend money for free, the nominal interest rate cannot be lower than the inflation rate, at least for very long. The reason is simply that if the US Dollar now has the same buying power as $1.05 in a year, a lender must charge an interest rate of 5% just to break even. Thus, the interest paid on securities rises with inflation.

Now, consider an investor who wants to buy a US treasury bond. There are two options: buying a newly issued bond or buying an existing bond. Purchasing a new bond from the treasury will pay the current higher interest rate. Since the interest rate paid on a treasury bond is fixed when the bond is issued, older bonds in the secondary market will pay lower rates. Thus, any investor will only buy these at a discount.

This means that banks that held many US treasury bonds as assets will see the market value of their assets decline substantially. In such a case, the bank’s liabilities remain the same while its assets have declined. There is a risk that depositors, fearing for the health of the bank, will withdraw their deposits further endangering the bank precisely at a time when the ability of the bank to sell its assets to pay depositors has decayed.

When a bank is run upon, the probability of getting back the deposits depends on how quickly one withdraws. If depositors expect other depositors to do this, they will as well. In other words, bank runs can be self-fulfilling prophecies. It is important to note that in the case of Silicon Valley Bank, the fears appear to have originated due to the assets of the bank taking a hit. In other words, it is possible that as market circumstances changed, Silicon Valley bank became undercapitalized.

So what does this have to do with housing and mortgages? The Federal Reserve has been raising rates in an attempt to fight inflation but these rate hikes put the financial system at risk. Now, when higher interest rates prevail, mortgages are more expensive and the bank takes a greater share of each home buyer’s fixed budget. This will tend to push housing prices down. Thus, to the extent the Federal Reserve rethinks its rate policy, there may be less additional softening in housing markets than there would have been otherwise.

John Schuler

John Schuler is a Senior Economist at Kukun with expertise in economics, statistics, and agent-based modeling. His research interests include real estate economics and banking. John holds a Ph.D. in Economics from George Mason University and a M.S. in Statistics from American University.

Published August 20, 2023