The Federal Open Market Committee meets today, and the question isn’t whether or not the Fed will cut rates, as was the case just a few weeks ago. That question has been answered by the Federal Reserve Board themselves, as speeches by Donald Kohn, Chairman Ben Bernanke and Janet Yellen very effectively conveyed the notion that a rate cut is in the offing.
Why another rate cut when the October meeting statement seemed so even-handed and noncommittal? Liquidity issues have resurfaced in credit markets and are once again commanding the Fed’s attention — and action.
With more and more financial institutions setting aside larger reserves to cover loan losses and restore their capital bases, this could crimp the amount of money available for lending. At the National Housing Forum in Washington, D.C., last week, it was interesting to hear one particular theme repeated time and again — that lack of liquidity in the mortgage market is a serious issue in need of immediate attention. This goes to show that liquidity in the credit markets is going to remain a front-burner issue for some time.
So, in steps the Federal Reserve with an interest rate cut designed to inject some confidence into the credit markets and keep money flowing. A Fed rate cut serves as oil on the hinges to markets in danger of seizing up.
How the consumer is affected
The biggest consumer impact of another interest rate cut is to the many prime mortgage borrowers facing rate resets now and in 2008. These are the homeowners who won’t qualify under the new foreclosure relief plan announced by the Bush administration.
Specifically, borrowers with adjustable-rate mortgages linked to Treasury yields will see resets that are considerably less painful than otherwise would have been the case. For LIBOR-indexed loans, sorry, it’s a different story. But for the Treasury-indexed ARMs due to reset, the plunge in one-year Treasury yields from 5 percent to just over 3 percent means a reset that is more manageable than if the Fed hadn’t been trimming interest rates in recent months.
If, for example, a borrower has a loan with a margin of 2.5 percentage points added on to the index, a looming reset results in a rate of 5.7 percent instead of the 7.5 percent that would have prevailed had the reset occurred in July. For a loan with a $200,000 remaining balance and 27 years to go, the payment increase from a start rate of 4.5 percent is a manageable $140 compared with the back-breaking $370 increase that would have prevailed just a few months ago.
Now $140 per month isn’t chump change, and certainly not to a household living paycheck-to-paycheck, but that is a gap that is more readily closed by cutting back on discretionary spending, selling unneeded items at a flea market, working overtime or taking a second job. To many borrowers facing rate resets and intent on staying in their homes, the Fed’s actions are providing much-needed benefits.