In 2010, then President Barack Obama signed the Dodd-Frank Act into law. After the financial crisis, many banks had to maintain a certain amount of liquid assets. If any loanees default, these institutions would still have enough funds to pay their depositors back and honor other financial obligations. Just as importantly, firms had to report their finances to the federal government every year. These rules impacted everything, ranging from credit card interest to the current 30 year mortgage rates.
More specifically, these requirements made it harder for banks to issue new mortgages or lines of credit. When firms can only lend a certain amount of money (as a percentage on their total assets), they will naturally be more picky. In addition, financial institutions had to incur ongoing accounting and regulatory costs because of how often they needed to report information to the government.
Recently, however, the Federal Reserve and other policymakers changed these regulations. In turn, the more flexible new requirements mean that it will be easier to get approved for a loan. Just as importantly, regional banks can now accept more applicants without bearing additional risks.
The Four Categories
The new regulations divided banks into four different groups based on their size. Regional firms with less than $700 billion in assets now have the least strict capital requirements. The amount of loans that they can issue, in relation to their assets, increased.
Additionally, institutions are only required to report their finances to the federal government once every four years. This will allow them to cut costs on hiring accountants and regulatory experts on a recurring basis.
These changes, combined, make it easier for consumers to get approved for a new credit card or loan. When banks have more funds that they can lend, they become less selective. Previously, these firms had to be strict and only picked the most qualified borrowers.
What Does This Mean for Consumers?
When banks have more customers (who borrow money), the damage per default goes down. For example, if a firm can only lend 10,000 consumers money, 100 defaults become problematic. However, if they issue debt to 20,000 borrowers, the losses from the 100 defaults are cut in half. In turn, the risk associated with each customer is also going to be much less.
Generally speaking, banks determine interest rates based on how likely the borrower will pay them back. Consumers with a lower credit score have to pay higher rates. This way, the bank’s potential revenue (from interest) offsets the risk that they are taking by lending out the funds.
All of this translates to low interest credit card payments. Moreover, we can expect to see the current 30 year mortgage rates to go down.
Accountants and lawyers are two of the highest paying professions in the market. When banking institutions have to report to the government on an annual basis, they need the right accountants and lawyers who will ensure that everything meets the legal requirements. Complying with regulations is expensive.
However, now that they only need to do so once every four years, the related costs will also go down. Just as with any other business, the price of purchasing a bank’s product (interest on the loan) will decrease when the firm’s expenses go down.
What does this mean for you? With a strong downwards pressure on interest rates, you might want to think about refinancing existing loans. Similarly, first time applicants are more likely to get approved for an even lower interest than on the current 30 year mortgage rates.
What About the Headwinds?
Many pundits and analysts are concerned about the recent changes. After all, the Dodd-Frank Act, they argue, is supposed to ensure that another financial crisis will not happen. When financial institutions issue too many loans, they are unlikely to pay back customers with checking or savings accounts when a lot of borrowers default.
However, this viewpoint is wrong for several reasons.
First, regional and small banks are the biggest beneficiaries from the rollback on restrictions. During the Great Recession, large firms were the ones that had to be bailed out, which cost the government trillions of dollars. Multinational corporate banks still have to deal with a lot of rules. Even though they are less restrictive than they were before, the new requirements on large financial institutions are nowhere near as liberalized as they are for local and regional banks.
Second, critics of the changes ignore some of the main other reasons that caused the markets to crash in 2007 and 2008. During the late 1990s, the Federal Reserve changed the way that they calculated inflation and stopped accounting for the increases in housing prices.
This meant that interest rates did not take into consideration the soaring property values. Otherwise, they naturally increase on mortgage loans to reflect this. Higher rates would have prevented the housing bubble from growing since less people would have taken out mortgages.
In addition, during the build up to the Great Recession, the government issued loans to candidates who otherwise wouldn’t qualify for them. They also subsidized banks who approved low-income borrowers for mortgages that they couldn’t afford.
Today, however, inflation takes home values into consideration and the current 30 year mortgage rates reflect that. The recent changes to the Dodd-Frank Act are mostly concerned with liquidity. They do not impact how inflation is calculated, nor is the government subsidizing loans or encouraging banks to lend to high-risk consumers.
Current 30 Year Mortgage Rates Will Go Down
More available funds to lend out and lower costs make life easier for both consumers and banks. Firms can approve more borrowers instead of turning down qualified applicants because of lending limitations. This, coupled with lower compliance costs, will make mortgage and credit card interest rates lower.
Just as importantly, these changes are happening while the major causes of the Great Recession are absent. We can put worries about another market crash to bed and look forward to a healthier economy.