Every banker who deals with mortgage loans has undoubtedly had this experience:

The customer comes in to talk about refinancing. You set out the terms, the costs of prepayment, new up-front fees, and other attendant costs.

You have thus given a clear picture of what the savings might be and how long the customer would have to live in the home to make the refinancing worthwhile.

Then comes the question: "But shouldn't I wait until interest rates are even lower?"

The only fair answer a banker can give is:

"If I could predict interest rates, I wouldn't be sitting on this platform. I would be lolling by the pool or playing golf."

Pitfalls of Forecasting

Still, predicting interest rates is an American pastime. And many financing institutions have gotten into trouble by thinking they have the magic key to the interest rate outlook.

One way bankers get into deep trouble is by relying too heavily on the past to predict the future.

We do this with stocks as well as fixed-income investments.

"This stock sold at $82 and it is now at $36, so it must be a bargain," is the way we think.

The trouble is, a stock or a bond is like a coin tossed in the air -- it has no memory.

When the Bottom Fell Out

Just because it once sold at $82 is no reason to think it must go back up there -- just as a coin landing head up nine times in a row still has a so-so chance of landing tail up the 10th time.

The best example occurred during the Great Depression. People saw stocks drop in the early stages and felt they were bargains, so they bought and held on. Then the stocks plunged to unimaginable lows.

Similarly, predicting interest rate movements on the basis of history can get us into trouble.

In the 1970s and 1980s, banks got into difficulty by locking in fixed-rate loans and investments because the yields were so much higher than had been available in the recent past.

They found out, however, that funding these fixed-rate assets with ever more costly short-term deposits eventually led to earnings squeezes or even the demise of the bank or thrift.

Coping with Volatility

So what can we do today to make the most of a highly volatile interest rate environment?

Many institutions have taken the attitude reflected in a sign found in one bank investment department:

"Good news and bad news: First the bad news -- we can't predict interest rates. Now the good news -- we finally realized this."

These banks are stressing variable-rate mortgages and other assets, recognizing that if we had had these in the past two decades, the thrift industry debacle would never have taken place.

When people demand fixed-rate loans, the savvy organizations either sell them immediately on the secondary market or,if they can't, turn down the loan request.

A Return to Fixed-Rate Loans

What scares banking industry observers is that many banks and thrifts are making the long-term fixed-rate loans again and keeping them, on the assumption that these will look good as time passes and interest rates drop further.

These institutions have obviously not learned.

This explains why top security analysts get scared when they see a bank with a gap -- either positive or negative -- that could seriously damage the bank on a sharp swing in interest rates.

They prefer to see a bank whose assets and liabilities are matched in interest rate impact, with profitability stemming from noncredit income and control of noncredit expenses, rather than from borrowing short and lending long or borrowing long and lending short.

Profiting from Rate Swings

To be sure, there are ways that bankers can still take advantage of interest rate swings.

Some follow the yield curve, feeling that this reflects the attitude of the whole marketplace toward the interest the rate outlook, which should at least give a slight edge in predicting the direction of rates.

A few years back, Ralph Nader, under the Freedom of Information Act, got the Federal Reserve Board members to admit that they look at the yield curve at least as much as they look at their own highly complex models to predict what rates will do.

The sixth sense of the professionals is a pretty good indicator, and this sixth sense is reflected in the slope of the curve.

Calculated Risks

Others play "what if" games to determine just how much they can lose or win if they operate with a positive or negative gap. At least this helps them know what is at risk if the market goes against them and they have to bail out.

But too many bankers and thrift executives are still willing to gamble on their own hunches or memories to predict what rates will do.

In doing so, they are as naive as the person who asks in his discussion of mortgage refinance, "Which may are interest rates going?"

Bankers who think they have the answer and invest accordingly are betting a whole lot more than people who gamble on interest rate trends to reduce mortgage payments on their homes.

Mr. Nadler is a contributing editor of American Banker and professor of finance at the Rutgers University Graduate School of Management.

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