In order to answer this question, it is helpful to understand the four major interest rates that are affected by the Fed:
Discount Rate (currently 5.25%) - the interest rate banks pay when they borrow money directly from the Fed. The rate has been largely symbolic in the past because hardly any banks took the Fed up on their offer!
You see, banks prefer to get short term financing less expensively by:
Nonetheless, many banks in today’s "credit crunch" environment have actually taken advantage of this opportunity to borrow from the Fed in recent weeks.
Fed Funds Rate (currently 4.75%) - the interest rate that banks pay when they borrow money from each other in the US. Like the Fed Discount Rate, the Fed Funds Rate is also determined by the Fed because banks in the US are part of the Federal Reserve System. The Fed's main role is to maintain "monetary stability" by keeping a close eye on the flow of money throughout the economy. One way they do this is by regulating the interest rates that banks charge each other for short term funds.
LIBOR Rate (Overnight LIBOR is currently 4.94%) – the London Interbank Offered Rate (LIBOR) is the interest rate that banks pay when they borrow money from other banks anywhere in the world (primarily in the international wholesale money market based in London). There are various types of LIBOR rates including the 1 week LIBOR, 1 month LIBOR, 6 month LIBOR, and 1 year LIBOR; these are the rates banks would pay if they want to borrow funds for 1 week, 1 month, 6 months, etc. Although the LIBOR rates are determined by the financial markets at any given time, they are very closely related to the Fed in that LIBOR most often changes when the market anticipates that the Fed will change the Fed Funds Rate. LIBOR is the base rate that is used on most adjustable rate mortgages (ARMs) in the US and large corporate / commercial loans. The reason LIBOR is used most often for US adjustable rate mortgages is because LIBOR is really the most accurate measure of a bank's cost of borrowing funds since most banks do business on an international basis.
Prime Rate (currently 7.75%) – the Fed Funds Rate plus 3%; this is the base rate used for most consumer loans such as credit cards and home equity lines of credit, as well as most small business loans. Like the LIBOR, the Prime Rate is also tied to the Fed Funds Rate.
In response to the economic slowdown that has occurred due to the current credit crisis, the Fed lowered the discount rate several weeks ago and they lowered both the discount rate and Fed Funds rate on September 18, 2007. Does this mean that more rate cuts are on the way or should we expect that the Fed will sit tight now that they have taken some action?
This depends mostly on whether inflation remains under control.
As the Fed lowers the Fed Funds Rate, the business and consumer-based interest rates of LIBOR and Prime will also go down. The Fed would be reluctant to continue lowering rates if their sentiment is businesses and consumers would start borrowing and spending so much money that inflation will go up significantly.
Remember, the Fed's main goal is to "maintain monetary stability" by keeping a close eye on the flow of funds in the US economy. It would be reckless to artificially encourage too much borrowing and spending as this would only artificially drive up asset prices and cause money to lose its purchasing power. This phenomenon is known as "inflation." The good news, at this time is inflation seems to be under control based on the latest economic reports.
How does the Fed affect mortgage rates?
If you have a home equity line of credit based on Prime or short term ARMs based on LIBOR, you should see an immediate reduction in your interest rate in the coming weeks. However, if you are considering a fixed rate loan or longer term ARM with a fixed period of 3, 5, 7 or 10 years, rates on those types of loans are not directly related to the Fed. Instead, these rates are closely tied to the Mortgage Backed Securities which trade on the bond market. For more on how this process works, please reference the previously posted blog, What's Going on with Mortgage Financing ??? (posted August 11th, 2007)
With all this in mind, it is more important than ever to work with a Certified Mortgage Planning Specialist™ who can decipher market conditions and help you make informed decisions in today's volatile market. A CMPS® professional can look at the Fed's recent decisions and current economic reports and help you make the right mortgage choices. Whether you have or are considering an ARM or a fixed rate loan; whether you are buying, selling or refinancing a home; whether you are dealing with a primary, vacation or investment property; now is the time to be dealing with an expert.
CMPS® professionals are committed, qualified and equipped to help you navigate today's turbulent mortgage marketplace. Don't delay in implementing the mortgage and real estate equity planning strategies that will make a positive impact in your life and the lives of your loved ones!
The FEDS earlier this week did lower interest rates. And for a few hours, even a day, mortgage rates did indeed go lower.
But today, euphoria of a lowered FED Funds rate AND a reduction of FED Discount rate wore off, the clear-eyed sobriety view of the future has taken hold. The ugly specter of inflation emerged from the mist today and the fear induced by that scarred horizon has taken root.
To understand this phenomenon, please read our earlier posting http://www.samcroskell.com/No%2c+that's+the+Fed's+Job+
30-year fixed rate mortgage rates have roared higher as mortgage bond buyers have swiftly lost their appetite for long term returns, fearing that the FED's rate reductions will fan the flames of inflation as the economy warms.
Tuesday's double reduction of the FED Funds rate and the FED Discount rate both by 1/2 percent was meant to provide the financial markets with greater liquidity and send a strong message that the government would respond to keep the economy upright. That message was heard and now analysts are responding with caution to the unexpected short term good news in light of long term inflation fears.
This behavior is yet another reminder that the financial markets are governed by two emotions, greed and fear. And fear is by far the more powerful of the two.
The FOMC, Federal Open Market Committee previously headed by Alan Greenspan, which impacts monetary policy in the United States acted decisively this week by lowering the Fed Funds rate AND the Discount rate both by .50%.
This move only momentarily lowered mortgage rates. But you may be asking "say what?", the Fed lowered interest rates and so mortgage rates should be lowered.
The FED board doesn't set mortgage rates, which are determined, not by the 10 year Treasury bond rate as many believe, but by the mortgage bond pricing. The bond rate does often move in concert with the Treasury, but mortgage bonds are priced on their own and sold on their own. Mortgages are a longer term commitment by the lender and are priced against the long term inflation and return expectation.
Short term interest rates are based against the FED funds rate, the overnight rate, which banks charge one another for daily borrowing to essentially balance the books "overnight". The PRIME rate is by custom, 3% higher than the FED funds rate, which is now at 4.75%, and thus the PRIME rate is now at reduced to 7.75%, from the previous 8.25%. This rate will impact most directly credit card, auto loan and other "short term" consumer rates. It is also generally the basis for HELOC's, Home Equity Lines of Credit.
The FED discount rate, the rate the Federal Reserve charges banks for monies borrowed for up to 30 days, has also been lowered by 1/2% to 5.25%, the 2nd such lowering since the September 11, 2001 terrorist attacks. The first lowering took place in mid-August, 2007. These loans to banks are also renewable. Monies borrowed from the FED at the discount "window", are used to meet short term borrowing and liquidity needs of the nation's financial markets.
What the FED is doing is meant to break the ice jam of liquidity in the markets - to allow those desiring to fund mortgages, commercial debt and other debt investors have been avoiding.
This also signals in no uncertain terms, the government's faith in the economy, commitment to keep the country's financial markets healthy and liquid and to meet any threat to the monetary well being of the United States.
The 3 month break from school ended today as we've commenced another school year.
Mother Nature marked the ocassion with an overnight dousing. This welcome moisturizing made for a dicey bit of traffic this morning. Sporadic showers expected the remainder of the day and then warm and dry is the forecast through the weekend.
Crickets have been chirping for a couple of weeks now, which means something about Fall's arrival, but it excapes me at the moment.
Still plenty of finger pointing and handwringing going on in the popular press, where far too many are writing about what happened but too few are writing about why the mortgage financial markets have melted down. Superficial pack journalists chasing the herd.
But a funny thing happened as I did some research resource reading today, I found a wonderful story.
It seems more than a dozen economists vacationing in Europe took a break to climb in the Alps.
After several hours they determined they were lost, completely without hope. The experienced mountain climber in the group of economists spreads numerous maps and charts out, scrutinizing each with furrowed brow and frequently checking the horizon.
Checking coordinates and working various formulae, he uses his compass, searches the skies for a sign and finally wets his finger and thrusts it in the air. A knowing smile breaks his strained face as he proudly exclaims to the other economists in the group "See that jagged mountain top on the horizon? My calculations tell me we're standing on top of it!!"
This epitomizes the turmoil in which we find ourselves presently with the liquidity of the secondary mortgage market. The ability of the market to properly determine the risk of the subprime and Alt-A mortgages hasn't yet arrived. And until risk evaluation is accurately determined, emotions - fear actually - will rule and rue the non-prime mortgage markets.
Happy Labor Day!!
Have ventured into the jungle of blogs this weekend and there's some pretty weird, ill-informed and downright damaged thinking in some places.
In one case, an entire blog's postings were about the ancient monied families manipulating the markets to damage and keep down the middle class through manipulation of the securities markets - read the mortgage meltdown.
If anyone with even a third of brain had read the news reports of late in the NYTimes, WSJournal or checked out the legitimate articles and postings on monetary policy and markets blogs they'd know the truth.
It's a reduction to this - there's no grand manipulative conspiracy, just the Wall Street market makers and their collaborators in the ratings services who abandoned their responsibilities and ethics to rate securities they'd not even scrutinized as AAA.
It's that sinister, that stupid and that simple.
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