Cost of Money? Priceless (almost).
December 16, 2008
[Note: The Fed has held several meetings since the date above but to date there has been no change to interest-rate policy. Since the last change to the Federal Funds and Discount rates, the releases which accompany the close of an FOMC meeting have largely been descriptions, outlines, evaluations and extensions of the kinds of "quantitative easing" programs (described below) which were made available to the markets. As such, the text below contains just a few updates to December's discussion.]
How low can you go? Pushing zero percent -- or a little above. The Federal Reserve slashed its target for overnight loans between banks to unprecedented levels, leaving the Federal Funds to wander in a range between 0% and 0.25%.
While a move in the target was expected, speculation about the size of the move ranged centered on perhaps a half-point trim, but with the actual, overnight-between-banks rate already trading well below those levels in recent weeks, the larger move was actually unsurprising.
More important that any change in rate policy was the discussion in the release which provided comfort to the market that even with the Federal Funds Rate target near zero, the Federal Reserve still has plenty of ammunition available to influence the economy. Discussions of "quantitative easing" -- geek speak for flooding certain markets with cash -- is the Fed's next likely course of action, and may take a variety of forms.
As an example, already in place and starting to function is the process of manipulating mortgage markets. A November 24 announcement that the Fed would purchase up to $100 billion of Fannie- and Freddie-issued debt and up to a half-trillion dollars of GSE and GNMA Mortgage-Backed Securities on the open market has driven at least 30-year conforming mortgage rates down to near 50-year lows. The Fed's announcement at the close of today's meeting reiterated support and perhaps expansion (if warranted) of that program. Other opportunities to manipulate markets are being considered, including outright purchases of Treasury Securities to drive interest rates even lower. Markets had already cheered the Fed's earlier announcement, and appeared to embrace this one as well.
[Note: The programs outline above were expanded in early 2009 to add an additional $750 billion of MBS to the Fed's balance sheet, another $200 billion for support by purchasing Fannie- and Freddie-issued debt, and a new program to purchase up to $300 billion in Treasuries, a kind of 'sponge' to absorb excess supply as it comes into the market, which also serves to keep interest rates low.]
The Fed's re-emphasis today is more important to the market than the change to short-term rates. As we moved late into 2008, certain kinds of lending came to a virtual standstill, so concerns have been more centered around the availability of money than they price of money, especially at the short-term end of the market. The Fed went on to say that the TALF program (also announced Nov 24) would be fully underway early in 2009, seeking to help promote small business loans, student loans, auto loans and other illiquid markets.
Even without the TARP buying up troubled assets, the troubles in lending are being addressed. Loans already on lender books have essentially become deterrents to new lending: bad loans remain capital drains, good loans on books cannot be easily sold (or sold profitably), and lenders cannot easily (or profitably) borrow against those assets.
In many ways, portfolios have become frozen, impairing the ability of a lender or investor to change or improve the mix of holdings to adapt to new market realities and get their books into a more balanced, solvent position. The TALF will serve to add some liquidity by providing financing to parties who wish to purchase those assets from their holders, freeing up capital for other productive use.
The Fed's program to drive first-mortgage rates down should have considerable ancillary effects, too, not by directly financing anything, but through the normal course of mortgage refinancing. Obviously, the program is aimed only at solvent homeowners with equity and good credit (among other requirements), but a lender holding a book of first mortgages will see at least someof those now-illiquid holdings retired, and the return of cash as a result will allow for a more natural rebalancing of books over time, rather than some fire-sale-at-a-loss situation to raise desperately needed capital. Of course, this process will take some time, but should serve to even help unwind many of the complex debt instruments so vexing the market. As well, fee income generated from refis produces profits and should help to support mortgage-related jobs -- not to mention strengthening household balance sheets and potentially pumping billions into the economy over the next year. Stimulus, indeed.
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Click here for an up-to-date graph and table of the Federal Funds rate.
Of course, the Fed's actions then or today have no direct effect on jumbo mortgage borrowers. With the emergency, up-to-$729,750 loan program coming to an end (replaced with an up-to-$625,500 loan limit in certain markets, then replaced again with the $729,750 limit in March), more jumbo borrowers will become exposed to higher, unsupported interest rates. However, the rebalancing of portfolios noted above may free up money for lenders to purchase or fund more of these high-quality loans, and that would tend -- on balance -- to push those interest rates lower. Until that happens, fixed-rate mortgage interest rates for jumbo (aka "non-conforming") borrowers remain rather high, and large-loan borrowers will probably need to continue to consider adjustable-rate mortgages as an alternative.
With short-term rates already low, borrowers with resetting ARMs not only have little to fear, but many will actually see declines -- some substantial -- in their new rates for the next period. This is particularly true for ARMs tied to Treasuries, but other indicators are heading downward as well. 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. The decline for MTA should continue for a while yet.
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 moved down a full three-quarters 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 3.25% 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.
That said, not all the benefits of falling rates will accrue to the holders of these products. Many HELOCs have already hit or will be hitting interest rate "floors" -- a lower limit on their interest rate. Instituted by many lenders after the huge decline in rates through 2003, many of those floors call for rates no lower than 4% or so, so borrowers already at those levels won't see any improvement in rate as a result of the Fed's actions today.
Also, after the last Fed cut on October 29, we did notice that not all lenders were passing along the full 50-basis-point cut, but instead made changes to their programs so as to pass along only some --or none -- of the effect of a lower Prime Rate. For example, a lender with a Prime + 0% rate (4.5% at the time) might have changed to a Prime + 0.25% rate (4.25%), passing along a portion of the nominal decline in rate to a potential borrower today but also enhancing the relative profitability of the loan in the future.
It is that opportunity to make profits or to enhance profits which is absolutely crucial to enhancing the availability of credit. Without the profit motive, what would be the point of lending into these troubled markets, particularly for second-lien position loans with a great potential for default with no recovery? In this regard, the Fed's latest move was not aimed so much at helping to lower rates for consumers -- it likely knows that there will be little direct benefit in that way -- but it does make profits more likely to happen for a lender, and that should help lenders to find lending to be more desirable, rather than simply hoarding cash or stuffing it into safe havens (like Treasuries) which do little to improve the economic outlook.
With mortgage markets more fully supported -- staring with the takeover of Fannie and Freddie in September, and moves by the Congress, Treasury and Fed -- we're more optimistic about the prospect for housing (and economic) recovery than many others seem to be. More help may also be on the way, and that could help us to turn a corner at a quicker pace than some gloomy forecasts might predict.
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