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Vince Foster: Interest Rate Risk is on the Rise, Time to Play Defense

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The bullish view on long-term interest rates is facing risks.

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On Friday, the Wall Street Journal reported one of the more interesting developments in credit markets that seemingly went unnoticed by many participants who were focused on geopolitical events.  In an article titled New Credit Scores to Ease Access to Loans:

A change in how the most widely used credit score in the U.S. is tallied will likely make it easier for tens of millions of Americans to get loans.

Fair Isaac Corp. said Thursday that it will stop including in its FICO credit-score calculations any record of a consumer failing to pay a bill if the bill has been paid or settled with a collection agency. The San Jose, Calif., company also will give less weight to unpaid medical bills that are with a collection agency.

The moves follow months of discussions with lenders and the Consumer Financial Protection Bureau aimed at boosting lending without creating more credit risk. Since the recession, many lenders have approved only the best borrowers, usually those with few or no blemishes on their credit report.

The changes are expected to boost consumer lending, especially among borrowers shut out of the market or charged high interest rates because of their low scores. "It expands banks' ability to make loans for people who might not have qualified and to offer a lower price [for others]," said Nessa Feddis, senior vice president of consumer protection and payments at the American Bankers Association, a trade group.


This is remarkable. The change in score is not as big a deal, markets and underwriters will adjust standards to a more liberal credit assessment. What is a big deal is the Federal government agency charged with protecting consumers from credit abuse has convinced the credit rating agency that certain delinquencies should be disregarded when determining creditworthiness. This has the potential to have deep and long lasting effects as borrowers conceivably are no longer being penalized for failing to honor their credit agreements.

Think about it. What incentive do I have to pay my credit card bill on time if there is no consequence for future credit needs?

One of the great benefits for acquiring credit  through a credit card, or other consumer credit avenues like at a retailer for big ticket items, is the process of building a credit history for future credit needs like buying a car or a house. The message from FICO, and more importantly the CFP,B is you now don't need to worry about paying on time as long as it's eventually paid in full.  This strips the concept of credit of one of its most basic fundamental agreements: the timely repayment of principal and interest.

On the surface this new credit score calculation will make it easier to qualify for credit because past delinquencies will be disregarded. However, it is likely that underwriters will adjust standards to compensate for more liberal scores. The irony is that the Fed has directed banks to adopt stricter underwriting standards when it comes to their securities portfolios. Banks are no longer able to depend on rating agency assessments when determining a bond's creditworthiness and must underwrite the credit based on its own fundamental analysis. Consumer credit scores should no doubt face the same underwriting scrutiny.

The demand for and availability of credit is the cornerstone of pricing in the bond market and it's not clear how this change in credit calculation is going to impact interest rates, and perhaps more importantly mortgage market supply. As a mortgage investor I want to see how this will impact spreads in what has been a very tight supply picture for most of the year. With the Fed nearing its exit from the mortgage market, and as we enter a very slow issuance period into the Labor Day weekend, investors may back away from what has been a relentless bid for bonds.

Friday morning on the heels of an announcement to send bombers back into Iraq, the long end of the yield curve traded at the lowest yields of the year with the 10-year and 30-year yields at 2.35% and 3.17% respectively. However, when it was apparent the equity market had shrugged off the headlines and rallying over 1% across the board, bonds lost their bid and yields closed at the highs of the day.
This type of intraday reversal can mark a change in momentum and I think it might finally be time for the market to consolidate these gains and work back towards the middle of the range. Add to the fact that that there may be a new wave of mortgage supply due to the liberalization of credit standards and investors have plenty cause for caution.

All year I have been an unrelenting bull on long-term interest rates and it's been a good run, but now it's time to play defense. Over the next few weeks as we wind up the summer and approach the pivotal Labor Day weekend investors should anticipate market weakness and a rise in yields. Between the Jackson Hole Fed conference at the end of this month, which is potentially the platform for mapping the Fed's exit strategy and the eventual winding up of the QE program in October, risk is on the rise at a level where price is most vulnerable. This is a recipe for an increase in volatility and cheaper opportunities on the curve.

Twitter: @exantefactor
No positions in stocks mentioned.
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