Only a day after Fed Chairman Ben Bernanke laid the groundwork for a potential cut in short-term interest rates, the Fed trimmed the Federal Funds and Discount Rates in a coordinated effort with central banks across the globe.

Speculation had been growing that the Fed would soon cut rates, reacting to a more pronounced slowing in economic growth and diminished inflation threats. Lowering the key short-term interest rate could eventually foster some additional economic growth, once the financial market crisis eases. At 1.5%, the Fed Funds target rate is approaching historic lows; a 1% rate seen in 2003 represented a 50-year low.

The Fed's overnight target rate for the cost of interbank lending of reserves is just that: a target. The actual cost of the money fluctuates both above and below that number as demands for those funds between banks waxes and wanes. These increases and decreases reflect stresses in the marketplace.

Banks unable (or unwilling) to borrow in open markets can instead borrow directly from the Fed, via the "Discount Window" at a 1.75% rate. "Discount Window" borrowing is said to carry a stigma, because a bank which approaches the Fed for funds is thought to do so only as a last resort, after all attempts to borrow money in open markets have been rebuffed. The public nature of borrowing from the Fed -- and the ensuing questions about asset strength or even solvency -- may keep banks from getting to the funds that they may desperately (or not so desperately) need to cover reserve requirements.

The Fed's ever-expanding Term Auction Facility (TAF) allows much of the same function of the Discount Window, but on an anonymous basis, and has been instrumental in maintaining some liquidity in lending markets. The Fed has continued to expand alternate lending facilities, including the TAF, the Term Securities Lending Facility (TSLF), and the Primary Dealer Credit Facility (PDCF). These are means of getting cash to troubled institutions, who pledge assets in exchange for short- and medium-term loans at very low rates. Of late, they've added a mechanism to address seizure in Commercial Paper markets. The Commercial Paper Funding Facility (CPFF) represents short-term loans to companies in both a secured and unsecured fashion. Non-asset-backed loans will be available by paying a fee or otherwise guaranteed.

Until recently, efforts to provide the market with liquidity had driven LIBOR rates sharply downward. Access to the TAF had served to temper demand for funds traded in US dollars on the London Exchange, but the recent investor panic - a flight from risk - has resulted in new stresses in cash markets. High demands for cash and cash-like instruments (primarily short-term Treasuries) and renewed distrust of assets being pledged -- even distrust of the solvency of the firms pledging them -- has driven LIBOR rates up sharply over the past few weeks.

After worrying about inflation for much of this year, markets have again become concerned that the economic slowdown is deepening. The fall in oil prices -- about 30% from their peaks -- has lent some optimism that inflation may have peaked, even if there are some pressures yet to work though the system. The decline in employment -- "resource slack" in the Fed's parlance -- means little wage pressures are forming, too, so inflation is somewhat less likely to be as grave a concern in the future. This fortunate happenstance has no doubt increased the Fed's willingness to lower interest rates.

In its statement, the Fed noted: "Inflation has been high, but the Committee believes that the decline in energy and other commodity prices and the weaker prospects for economic activity have reduced the upside risks to inflation."

For much of the spring, mortgage interest rates firmed along with inflation concerns, then flared even higher during the Summer months along with rising concerns about Fannie and Freddie's solvency. With that concern answered by the move into conservatorship, rates declined measurably for a time, only to be pushed higher again by market stresses and the realization that the risks of investing in mortgages has not only not diminished, but may still be increasing.

That being the case, the ability for firms to begin to shed bad mortgage-related debts may begin to loosen underwriting standards somewhat (over time) and may also serve to lower interest rates. However, the $700 billion plan (actually, about $810b in total) to have the government acquire bad mortgage bets hasn't yet gotten underway, and the package is probably actually more important to other forms of lending which have recently become victims of the market storm. Getting rid of bad loans may ultimately improve firms' willingness to lend, a key component of recovery; however, making loans available at all is one thing, but making them available at low prices quite another. With profitability still difficult and capital so dear, rates could be slow to fall for many borrowers, at least until balance sheets are re-balanced.

Aside from the influences of inflation and growth, mortgages remain out of favor among investors, what with banks failing and announcements of multi-billion dollar losses on older loans still evident. That makes investors wary of buying any new loans, even good quality ones, and in order to attract investors to buy mortgages, higher yields -- reflected in higher rates -- are required (relative to other fixed-income investments). The ability to make new, better-quality loans at higher yields (or spreads over incoming costs of obtaining funds) are the ingredients for profitable lending, and restoring balance to troubled loan books. Together, these represent keys to lender's willingness to keep lending, instead of simply holding onto more cash in troubled times. Presently, there are virtually no active investors in mortgages, save Fannie Mae, Freddie Mac and the Treasury.

Click here for an up-to-date graph and table of the Federal Funds rate.

As mentioned above, lower overnight and short-term rates, coupled with the Fed's Term Auction Facility (TAF), have served to press common ARM indexes back down. LIBOR especially has benefited from the Fed's anonymous auction of fresh cash to lend. Treasury values are holding at multi-year lows, and LIBOR rates have moved closer to their normal relationship with other interest rates.

In mid-September, though, stresses in overnight lending markets caused certain LIBOR rates to double on an overnight basis. These rates have become unpredictably volatile lately, rising and falling amid the flights-to-cash engulfing the market over the past few weeks. The short-term funding storm has begun to infect longer-dated LIBORs, and some ARM borrowers will likely see a kick higher in their interest rates and monthly payments as a result.

For Jumbo (aka "non-conforming") borrowers, fixed rate mortgage interest rates remain rather high. Temporary changes to Conforming loan and FHA limits may allow some borrowers access to new mortgage funds at lower rates, but those programs are just getting underway. If nothing else, Jumbo borrowers could consider new ARMs as a quasi-temporary product if a fixed-rate is too pricey for their budget.

Holders of ARMs tied to the COSI, COFI, or other deposit-based indices are finally seeing rates decline after a period of spirited competition for deposits served to keep rates high. The Fed's moves, coupled with the TAF and expansion of the TSLF to include auto loan and credit card securities are serving to lessen the demand for deposits, meaning banks can pay lower rates for those funds (and in turn, hopefully lower rates for loans, too). The MTA has finally begun to reflect lower interest rates for one-year Treasuries and has been stepping downward more noticeably this year, helping borrowers whose short-term (often PayOption) ARMs become somewhat more affordable.

Holders of short-term PayOption ARMs should know that the true ("fully-indexed") rate of interest on an MTA-based ARM has finally fallen back in line with LIBOR-based ones. Despite that fall in rates, borrowers making a "minimum payment" as though the interest rate is just 1% or 2% need to be aware that they are accruing negative amortization at a rapid pace. Borrowers with minimum-payment Option ARMs are becoming delinquent at a more rapid pace, as rising mortgage balances and falling home prices make "ownership" less compelling. Also, those making interest-only payments may continue see their costs go up and up even as their loan balance remains steady. Some are likely refinancing to more fixed-rate products.

Click here for a graphic demonstration of the relationship between the Fed Funds and mortgages.

As the Prime Rate is heavily influenced by any move in the Federal Funds target rate, it has moved down a full half-percentage point as a result of the Fed's move. As a market interest rate, there have been periods when the Prime has moved well in advance (or well after) any Fed move, but the relationship between Fed Funds and Prime has strengthened considerably over time.

Contrary to popular belief, the Fed has no control over the Prime Rate or any other market-based interest rates, but the Fed's observations about market conditions and changes to monetary policy do influence the overall cost of money. The decline in the Prime over the past few months has no doubt brought relief to borrowers with Home Equity Lines of Credit (HELOCs), who watched their interest rates more than double during the Fed's 2004-2006 cycle of increases. Over that time, the Prime Rate jumped from 4% to 8.25%, mirroring the 425 basis point increase in the Fed Funds rate. The present 4.5% prime rate may be especially helpful to those whose HELOCs are part of a "piggybacked" mortgage origination, as that doubling in interest rate on a line taken in lieu of a down payment likely caused some borrowers a fiscal headache. See the latest averages for HELOCs here.

Good credit quality 'conforming' borrowers now shopping for variable-rate products tied to short-term indicators will generally find credit conditions to be mostly stable at the moment. Lenders are aggressively seeking new business from solid borrowers with strong equity positions, so rates and fees may actually be improving for certain equity seekers. Borrowers with non-conforming credit needs will probably continue to find a challenging credit environment, and should be prepared to shop aggressively to find a suitable loan.

Want to see today's ARM indexes? Click here.

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