Again last week, financiers failed to answer the major question dogging Wall Street: What is the “right” risk model to use for mortgage lending?  The models of the past are being proven to have been wrong.

So, why do risk models matter? 

Because the basic tenet of lending states that the riskier the loan, the higher the interest rate that should be charged on the loan.  If the risk is unknown, then there can’t be an interest rate. 

If there can’t be an interest rate, then there can’t be a loan.

This is one of the reasons why a few lenders chose to stop making loans last week.  The decision wasn’t made because the companies are going bankrupt, it’s because they can’t determine what their loans’ interest rates should be. 

Sometimes, the safest course of action for a bank is to sit on the sidelines until the market finds direction.

With very little data hitting the wires this week, expect markets to move wildly in response to Hurricane Dean’s damage toll, stock market activity and public statements from the Federal Reserve. 

If the Fed signals that the economy is slowing down because of the credit markets or if the storm causes more damage than is expected, expect mortgage rates to fall as inflationary pressures will subside. 

Inflation is the enemy of mortgage bonds so less inflation means higher bond prices (and lower mortgage rates).

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