Dangers of prolonged, sharply rising interest rates

The following is a brief excerpt from the book.

One of the reasons so much of the interest rate risk has been shoved to the households rather than banks is because of the growing power and influence of the major banks in Korea. In an environment of sharply rising interest rates, it will be the Korean households that will likely be most devastated by such a crisis. Banks will also be negatively impacted by such a crisis but not as much as the households, because the banks will simply raise their lending rates to offset the overall rising interest rate environment.

The large corporations in Korea suffered and learned in such a hard way during the Asian economic crisis that they have continued to pile on high amounts of cash and have reduced debt in the past ten years, vowing not to repeat the mistakes of taking on too much short-term debt without adequate protection.

Korea should brace itself for much higher interest rates in 2011 to 2013. Average mortgage rates in 2011 to 2013 could jump to as high as 8 to 10 percent, from the recent 5 to 6 percent. Corporations, financial institutions, and households should brace themselves for much higher interest rates and set aside adequate amounts of assets and cash to survive such a drastic rise in interest rates.

Given the extreme dangers of prolonged, higher rates for Korean households with high amounts of debt, why does the percentage of long-term maturity fixed-rate mortgages in Korea represent such a small percentage of household loans? One of the key reasons for this is because Korea lacks experience in the development of household finance, especially with regards to household loans.

A major reason long-term (twenty- to thirty-year) fixed rate mortgages are so common in the United States, for example, is because the United States went through the excruciatingly difficult period of the Great Depression from 1929 to 1930s. Prior to the Great Depression in the United States, the standard housing mortgages was mostly short-term. It took the Great Depression and massive personal bankruptcies in the U.S. to redraw the way people purchased houses. This included extending the terms of the mortgage loans and having most of these loans amortized at fixed rates, thereby reducing the overall interest-rate risk for the consumers.

Many people in the United States learned the hard way that having too much household debt on a short-term, floating-rate basis carries too much risk. As thousands of people in the United States filed for bankruptcies in the 1930s, Americans began to use more conservative fixed rates and longer-term mortgages after the Great Depression. Hopefully, Korean households may not need to learn the importance of conservative borrowing the hard way, by suffering like the people in the United States in the early 1930s who were devastated from severe hardships due to excessive leverage.