Friday, August 17, 2007
In Thursday evening's blog, we made the case that the Fed needed to cut rates and fast. Friday morning, much to our surprise and delight, they did just that. However, they only cut the discount rate, which applies almost entirely to banks, and not the fed funds rate, which banks use to set rates they charge to their customers. The half percent drop in the discount rate from 6.25% to 5.75% will provide needed liquidity to the banks and has stabilized the markets -- for now. In our judgment, however, unless the Fed cuts the fed funds rate they will continue to be knee deep in "dragons" (see Thursday's blog). Here's the problem as reported by CNNMoney.com A buyer in 2005 with poor credit and limited means might have signed on for a $200,000 2/28 hybrid ARM[adjustable rate mortgage], locking in a fixed rate of 4 percent for two years. After paying $955 a month, the bill would now be set[in October]to spike to $1,331, a 39 percent increase. According to Moodys.com, there are $50 billion of these hybrid mortgages coming due in October alone. Many of these homeowners will not be able to afford the new higher rates and will join the ranks of people trying to sell their properties. With too much real estate already on the market the odds are high that the real estate situation may worsen in the months ahead. If the Fed cuts the fed funds rate, banks will cut their prime rates. Since many adjustable rate mortgage rates are directly or indirectly tied to the fed funds rate, that would mean that the upcoming interest rate reset for the aforementioned mortgage holders will be much more modest than it would be without the rate cut. We believe that the real estate issues in the US are still mostly contained within the subprime arena. The problems, however, threaten to spill over into the prime mortgage market if too much real estate comes on the markets as a result of defaults caused by these adjustable resets. The Fed can say that they are not in the real estate business, but if they do not offer some sort of palliative to the subprime market that will keep people in their homes and paying their mortgages, a broadening real estate slump could derail the economy. In our minds, the time to deal with the problem is now and not when it is a full blown crisis. A cut in the fed funds rate will also assure consumers and, more importantly, employers in the US and the world that a recession is not likely.