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HSH on the latest action by the Federal Reserve

Fed Does Nothing, As Expected

August 5, 2008

As the economy remains fragile, the Federal Reserve Open Market Committee decided today to leave key short-term interest rates unchanged. The Fed last made a change to policy in late April, and has been holding steady since then. The Federal Funds Rate remains at 2%, while the "discount" rate -- the cost of money for a bank borrowing directly from the Fed -- held at 2.25%

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.

Banks unable (or unwilling) to borrow in open markets can instead borrow directly from the Fed, via the "Discount Window" at the 2.25% 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 new Term Auction Facility (TAF) allows much of the same function of the Discount Window, but on an anonymous basis, and has been instrumental in restoring liquidity to lending markets. Notably, LIBOR rates have declined sharply, as the Fed's offerings of cash has served to temper demand for funds traded in US dollars on the London Exchange.

Although today's lack of movement was expected, there have been a varying number of calls from the market for the Fed to at least consider raising interest rates to start to address rising price pressures. In the release that accompanied the close of the meeting, the Fed starkly noted: "Inflation has been high... and some indicators of inflation expectations have been elevated."

They also specifically noted that "the upside risks for inflation are also of significant concern to the Committee." A concerned Committee would surely prefer raising interest rates to standing pat, but they are loathe to increase funding costs while "financial markets remain under considerable stress."

The Fed hopes that inflation will chill on its own. The recent slide in oil and certain commodity prices will need to remain in place for a while to have much effect, but lower prices at the pump and in the bottom line of invoices would free up cash to spend elsewhere, to the benefit of the broader economy. As well, with hiring now in a seven month decline, the additional drag of the declining labor markets may help to ease price pressures further. Still, it's a gamble that inflation will ease, and outlook which they described as "highly uncertain", but the Fed has little choice but to roll the dice and hope at the moment.

Mortgage interest rates firmed in recent weeks along with rising inflation concerns in the market and renewed troubles at banks and even at secondary marketers Fannie Mae and Freddie Mac. With the passing of the housing bill and the adjournment of Congress, things have quieted considerably in the past week, and rates have begun to settle back somewhat.

Aside from inflation concerns serving to keep longer interest rates firm, 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 ways 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.

Despite the above, and indications that the Fed's next move will be one of raising interest rates, the timing of the move remains uncertain. The Fed next meets in September, and depending upon conditions over the next six weeks could possibly bring the first quarter-point move. However, that's unlikely, and with the meeting in late October just days before the presidential election being even less likely, our bet at the moment is that the first move upward will come in December. Of course, the Fed doesn't need to wait for a formal meeting to raise (or lower) rates, but surprising the markets is usually a bad idea, particularly in this environment.

HSH's Index Update Service delivers the ARM indices you want -- Treasuries, RNYs, LIBOR, COFs, usury rates, and many more -- every business day. Click here!

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

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.

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, no change is likely to occur right now. 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 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 improving 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.


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