Interest rates: A closer look at default

Default effect: lenders want higher rates if there is greater concern over the ability to collect on the loan. This can be affected by the credit worthiness of the borrower or the collateral that secures the loan.

Lending money can be a risky business.  In late 1998 the business press was filled with stories about the default of Russia on some of its loans as well as the bankruptcy of many banks and companies in Indonesia, Thailand and other casualties of the Asian financial crises.  Closer to home the taxpayers of Rhode Island lost money when the bioengineering company the state loaned money to went out of business.  The fact is all borrowers are not the same - some are more likely than others to find themselves unable to make the payments.  If a lender expects to find it more difficult to be paid then the interest rate is likely to reflect this higher risk.

But how do you determine the risk? There have been some companies that have emerged to "rate" the credit worthiness of companies and governments.  Moody's is one of these companies. What they do is have accountants look at the books, fancy versions of the income and balance sheets we talked about earlier, to determine the likelihood of the borrower to pay back the loan. For example, during the Asian crisis when banks and companies were going bankrupt in large numbers, interest rates skyrocketed to reflect the higher risk. The same thing happened in Brazil in 1999.  When the Brazilian currency was devalued, interest rates rose above 40 percent to protect lenders from the greater risk of lending to Brazil and Brazilian companies.  When it comes to companies, the best credit rating would be the Aaa rating. 

Below you will find four simple examples that point out the role played by default risk in explaining interest rate differentials. 

Example 1: Would you expect interest rates for 30 year mortgages to be higher or lower than 5 year car loans?

The maturity effect would suggest the car loan would have the lower rate, but the default effect would suggest the value of the collateral would be better for a house than a car. It would be easier for a lender to get their money back from repossessing a house than repossessing a car.  Once you drive the car off the lot the depreciation is substantial and the lender will never be able to recoup the loss if there was a need to quickly repossess the car.  This also helps explain why the interest rate may come down as you put down a larger down payment.

Example 2: Would you expect a loan to the US government to be 'safer' than a loan to General Motors?

The market's answer to this question is evident in the graph below. In the post W.W.II period we find the rate differential may vary, but rates on corporate bonds (Aaa) tend to be higher than rates on government debt. The market clearly charges corporations a "risk premium" to compensate for additional perceived risk.

Example 3: Would you expect a loan to GM to be 'safer' than a loan to Generic Motors, a small auto repair shop?

We might find that GM has a AAA rating while Generic Motors has an A rating, in which case we would expect the interest rate on a loan to GM to be lower. The risk analysis can be extended to countries, the risk associated with a loan to war-torn Bosnia is likely to be higher than the risk on a loan to Germany. In the 1980s we saw the emergence of Junk bonds - securities that carried a very high risk factor and thus carried very high rates of interest to compensate for the risk.

Example 4: Would you expect the interest rate on US government loans or loans to state and local governments to have lower interest rates?

You would expect there would be more risk in lending to local governments than there would be to the federal government since there have been instances where local areas have been unable to repay their obligations / debts. How then do you explain the fact municipal rates are lower than federal debt rates? The answer is in the tax treatment of the rates. The interest you earn on municipal bonds tend to be tax free so the actual (before-tax) rate can be lower and still provide the holder of the debt with a higher rate of return. For example, if the interest rate is 10 percent on a federal bond and the tax rate on interest income is 34 percent, then the interest earned will be 6.6 percent (10 - .34*10) = 6.6. In this case the holder of the may not ask for the full 3.4 percent as a default risk and therefore the actual (nominal) rate on the municipal would be lower. If the rate on the municipal bond was 7 percent, then the municipal would pay a slightly higher after-tax return which would compensate for some additional risk.