Now that we see interest rates raising many borrowers are questioning why when the Federal Reserve Bank (FRB) has not raised the official Australian cash rate. It is a fair question and the answer is linked to the current Sub-Prime crisis in the United States.
It is often said that when America sneezes the remainder of the world catch cold. Finance is a typical example of that because the finance markets of the world are so closely linked. When a market the size of the USA has a problem all other markets see that lending money to them has an added risk so they raise the interest rates to counter the added risk element of making a loan.
It affects Australia, and all other nations, in the following manner:
- Banks and mortgage funders buy the money to fund your mortgage loan at the 90-day bank bill rate. (This rate is set by supply and demand worldwide and being a free market rate it floats up and down by the minute.)
- At this moment the 90-day bank bill rate is higher than the Australian FRB official cash rate.
This means that both banks and non-bank lenders are paying more for the money they buy.
- This means that the Australian FRB official cash rate is irrelevant to the market. It can be compared to a radio commentator stating on the 8am news that bananas are selling in the supermarkets at $2.50 a kilo. When you get to the supermarket they are all priced at $3.50 a kilo. You now have a choice to buy the bananas at $3.50 a kilo or not buy them at all. Why? Because the statement made on the radio is irrelevant to the existing market conditions.
- Many ask why the lenders cannot ride this tide of high cost money until the market stabilizes? History tells us that the cost of money will stabilize at some time; what it doesn't tell us is whether rising interest rates will stabilize this week, next month, the year after next or some ten years from now. The next thing you need to understand is the profit margins on loans.
- The difference between what you, the consumer, pays for the loan and what your lender pays for the loan is between 1% and 1.5%. Due to normal market competition it is often closer to 1% and therefore there is virtually no space between what they make on the loan and the costs of running their businesses for them to soak up any rise in the cost of the raw materials. In this case money is the raw material. Therefore they have no option but to raise the rate that they charge you.
During the past week (commencing Monday 24 September 2007) almost every lender, both bank and non-bank, have made adjustments to their loans by either raising rates or reducing the amount they are prepared to lend due to interest rates rising. But this is for the next article.
