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CHICAGO’S CONDO TROUBLES — This Mort­gage Guy is Smack in the Mid­dle…  02/24/09

Please enjoty the Tribune’s arti­cle and watch their video inter­view of me.  Talk about being at the cen­ter of the entire meltdown…

CREDIT MARKETS CONTINUE TO STAGNATE

WATCH VIDEO EXPLANATION

SEPTEMBER 29, 2008 — WSJ

Credit Mar­kets and the Real Economy

By MICHAEL T. DARDA

The Trea­sury bailout plan to recap­i­tal­ize the U.S. bank­ing sys­tem may help the U.S. avoid a deep and pro­tracted reces­sion. But even if the plan suc­ceeds, it almost surely will not pre­vent a recession.

The major rea­son for this is that the credit mar­kets have been under incred­i­ble stress for well over a year, and have recently taken a sig­nif­i­cant turn for the worse. Dur­ing the last two weeks, the spread between Libor (the cost of bor­row­ing between banks) and the rates on zero-risk Trea­sury bills exploded to more than 300 basis points, the widest gap since Octo­ber 1987. This kind of stress reflects fear and a lack of trust among banks, which will be reflected in the real econ­omy with a lag.

The commercial-paper mar­ket — which funds auto loans, credit cards, and short-term work­ing cap­i­tal for busi­nesses — also is under incred­i­ble stress. Spreads on asset-backed com­mer­cial paper rel­a­tive to com­pa­ra­ble matu­rity Trea­surys rose to more than 500 basis points in recent weeks. Not sur­pris­ingly, the commercial-paper mar­ket shrank by more than $100 bil­lion in the last two weeks. It’s down by more than $520 bil­lion since the sum­mer of 2007, when the credit cri­sis began.

The Fed­eral Reserve’s Senior Loan Officer’s Sur­vey also shows record frac­tions of loan offi­cers report­ing tighter lend­ing stan­dards for the broad swath of busi­ness and house­hold credit. Sim­i­lar spikes in lend­ing stan­dards dur­ing 1990 and 2001 were marked by recession.

If a reces­sion is unavoid­able, the ques­tion is how deep and long it will be. While sec­ond quar­ter real GDP showed respectable 2.8% growth, trade was the only thing keep­ing the econ­omy above water: Gross domes­tic pur­chases con­tracted dur­ing the sec­ond quar­ter. Gross domes­tic pur­chases also con­tracted dur­ing the fourth quar­ter of 2007, and only rose by 0.1% at an annual rate dur­ing the first quarter.

More bad news: Real retail sales growth has been neg­a­tive on a year-to-year basis for nine con­sec­u­tive months, the longest streak of declines since 1991. This data, and the tremen­dous spike in both job­less claims and the unem­ploy­ment rate, are tell­tale signs of an econ­omy that is in reverse gear.

The best we can hope for is that the down­turn remains mild — and for a mod­est recov­ery to take shape in the sec­ond half of 2009. But the fis­cal poli­cies of the next admin­is­tra­tion will play a cru­cial role here. If tax rates on cap­i­tal and labor are raised sharply, a hoped-for recov­ery may be jet­ti­soned altogether.

Some have sug­gested we’re close to the hous­ing price bot­tom. That’s hard to imag­ine, as new home sales just sunk to new cycle lows in August while inven­to­ries remain at ele­vated lev­els. New home sales bot­tomed three years before prices in the hous­ing recov­ery of the early 1990s. Home prices also remain ele­vated rel­a­tive to rents in a way they were not at the bot­tom of the home-price cycle in the early 1990s.

On the infla­tion front, the most recent bout of credit stress has a sil­ver lin­ing: Indus­trial com­mod­ity prices have declined sharply. At the same time, bond mar­ket infla­tion expec­ta­tions recently receded to the low­est level in six years. Gold has risen aggres­sively off the lows of mid-September but remains below the March peak. The dol­lar is off the Sep­tem­ber highs, but is also well above the record lows seen in April. Col­lec­tively, these market-based sig­nals sug­gest that head­line infla­tion will ease from the 17-year highs seen in July.

The likely eas­ing in infla­tion in the months ahead may not be per­ma­nent. In the past two weeks, the Fed’s bal­ance sheet (the asset side of the mon­e­tary base) has exploded by nearly $300 bil­lion. Yet this avalanche of liq­uid­ity has done lit­tle to relieve strains in credit mar­kets. In other words, we can­not expect central-bank liq­uid­ity to be a sub­sti­tute for financial-sector solvency.

The long-term out­look for price sta­bil­ity now depends on whether the Trea­sury pays for the bailout by sell­ing U.S. debt to the pub­lic, or if the Fed finances it with printing-press money. If it is the lat­ter, there will be an infla­tion­ary legacy that long out­lasts the 2007–2008 credit crises.

Mr. Darda is the chief econ­o­mist of MKM Partners.

CHICAGO MORTGAGE MARKET — The Credit Tight­en­ing Con­tin­ues 02/28/08

We have arrived.

It is now more impor­tant than ever for all home buy­ers and real estate investors to secure financ­ing first and fore­most, prior to contract… if any pos­si­bil­ity exists of pur­chas­ing (or refinancing) a home or prop­erty. The finan­cial mar­kets and mort­gage indus­try is incred­i­bly volatile cur­rently, with changes occur­ing from all sides on a weekly basis.  It really is a his­toric time for all of us.

Although hous­ing and mort­gage money in gen­eral is in a bit of a deba­cle, Chicago’s hous­ing and mort­gage mar­ket is much bet­ter off than most hous­ing and mort­gage mar­kets through­out the rest of the coun­try.  How­ever, there are still obsta­cles ahead.

Just within the last 9 months (the last 3 months dra­mat­i­cally), Fan­nie Mae, Fred­die Mac, invest­ment and retail banks and mort­gage insur­ance com­pa­nies have felt the market’s pres­sure and sub­stan­tially tight­ened guide­lines and bor­rower require­ments for mort­gage qualification.  Loan-to-value and debt ratio stan­dards are regress­ing and credit/scoring cri­te­ria is ris­ing.  After March 3rd, nearly all mort­gage insur­ance providers will revise credit score require­ments upward to a min­i­mum of 620 overall.  For higher lever­ag­ing sit­u­a­tions (no money down/100% financ­ing, 95% financ­ing etc), 660 will be a floor for pur­chase and refi­nance trans­ac­tions for most MI car­ri­ers despite what loan prod­uct guide­lines indi­cate.  Seller con­ces­sions above 3% will reduce the allow­able LTV on many first time buyer pro­grams by the amount of credit incurred.  Rea­son­able terms on jumbo loans (rates/requirements etc.) are typ­i­cally capped between $1 and $2 mil­lion. Stated income prod­ucts designed for upper ech­e­lon, cor­po­ra­tion own­ers and self-employed types of bor­row­ers (to avoid ana­lyz­ing hun­dreds of pages of tax returns), have amost sub­sided entirely.  City and county pro­gram income require­ments for low to mod­er­ate income earn­ers has recessed whereas per­sonal income and wages have increased con­sec­u­tively for 5 years running…disqualifying many due to higher salaries.

Chicago’s biggest hur­dle are con­do­minium require­ments.  Condo guide­lines have changed to the extent of hav­ing approx­i­mately 1/3rd of  investor pool avail­able now to choose from as was avail­able just a few months ago.  Just for exam­ple, sev­eral retail banks and mort­gage lenders com­pletely pulled out of lend­ing 2nd liens and HELOCs in Octo­ber of 2007 and addi­tion­ally ceased many types of lend­ing on any and all new con­struc­tion and new condo con­ver­sion projects altogether…unless sub­stan­tial pre­sale or down pay­ment require­ments are met or the project is already on the investor’s approved list.  Even lan­guage con­tained within some con­do­minium dec­la­ra­tions and bylaws can cre­ate non-warrantable sta­tus for the condo devel­op­ment and dis­qual­ify it for financ­ing altogether…unless the decs/bylaws are amended and re-recorded cor­rectly.  Every investor will require a full project review mov­ing forward.

So why is all of this hap­pen­ing?  The “mar­ket pres­sure” indi­cated in the pre­vi­ous para­graph is a note­wor­thy cul­mi­na­tion of vari­ables, not just “sub-prime”:

Initially, the accel­er­at­ing mort­gage default rates were mostly tied into sub-prime and Alt A mort­gage prod­ucts.  Hence, investors tak­ing bil­lions of dol­lars of losses on these types of CDO’s and MBS’s no longer would col­lat­er­al­ize these prod­ucts, basi­cally mak­ing them unavailable, or, initiated a much higher
risk spread pre­mium (rate) for the prod­uct to carry it — putting the prod­uct out of scope for most bor­row­ers as the money is just too expensive.  So these prod­ucts have mostly dis­ap­peared or have become use­less.  These prod­ucts were gen­er­ally issued to sub-prime and Alt-A credit bor­row­ers — many of whom would not have qual­i­fied for financ­ing accord­ing to con­form­ing triple A eli­gi­bil­ity requirements.  This default issue was the start of the tight­en­ing of credit on the sub-prime side and should have
been con­tained there.  How­ever, upon last year’s news of the sub prime deba­cle, hous­ing started to slow in con­junc­tion with weak­en­ing eco­nomic con­di­tions and slowdown…and, of course, the investors were watch­ing this.  The con­sumer was also watch­ing this.  Now add to that…

1.  Some of the CDO’s were triple A rated and shouldn’t have been, hence, A paper CDO’s start tak­ing losses.  Now, the sub prime tight­en­ing has spread to A paper.  The A paper investors that took min­i­mal or no losses are con­cerned enough to tighten any­way before any losses are incurred. Fan­nie, Fred­die, Banks and Investors and MI com­pa­nies con­tinue to tighten credit require­ments, cre­at­ing much less prod­uct avail­abil­ity and very restric­tive prod­uct avail­abil­ity (com­par­a­tively speaking).

2.  Consumers who are well qual­i­fied to pur­chase are stand­ing on the side­lines wait­ing for some kind of fore­see­able “bot­tom” to occur…and many whom are not wait­ing and try­ing to pur­chase, are not clos­ing due to unre­al­is­tic offers being pre­sented to sell­ers (20% — 50% below ask­ing). This is clearly not help­ing to deplete cur­rent inven­tory
of homes on the mar­ket and adding to the hous­ing decline in terms of price.

3.  The con­sumers who do want to buy right now and have mar­ginal cred­it­wor­thi­ness may not qual­ify now due to this tight­en­ing of credit. Again, this is not help­ing to deplete the over­age of hous­ing inven­tory and, again, adds to declin­ing prices.

4.  The declin­ing prices and increas­ing inven­tory are caus­ing fur­ther tight­en­ing of credit.

5.  This fur­ther tight­en­ing of credit and declin­ing sales/prices have depleted equity posi­tions in owner’s homes.  Now, qual­i­fied bor­row­ers who financed 95% or 100% within the last two years can­not cap­i­tal­ize on refi­nanc­ing to lower mort­gage rates is some cases (due to the tighter credit/equity require­ments of loan pro­grams).  The sub prime bor­row­ers are sub­ject to the same thing, how­ever, their rates will likely increase when the fixed period ends — putting them in a posi­tion of default­ing should they
not be able to make the higher payments.…and they can­not refi­nance due to the tight­ened credit require­ments and flat to declin­ing value of their home.…which leads to.…

6.  More defaults, increas­ing inven­tory, price declines and/or lack of appre­ci­a­tion, owner’s equity depletion, the inabil­ity for some to refinance…

7.  Fur­ther­ing the slow­ing eco­nomic con­di­tions due to uncer­tainty of ever­thing and less spending;

8.  Furthering poten­tial reces­sion, higher job­less claims, infla­tion at 2.7% and ris­ing (in the short term)…

9.  Again, fur­ther­ing the tight­en­ing of credit.…

10.  And buy­ers and investors still stand­ing on the side­lines waiting…waiting…waiting.…..and the cycle continues.

The Fed only reaf­firmed yes­ter­day and today what was already known by mort­gage plan­ners and loan offi­cers in the mort­gage bank­ing indus­try; by indi­cat­ing in their state­ments before con­gres­sional lead­ers that this excess tight­en­ing of credit will only exac­er­bate the prob­lem we all face of hous­ing mar­kets poten­tially wors­en­ing before rebounding.  There is no real fix for the prob­lem other than to let it carry through its nat­ural course of action.  Note that the eco­nomic stim­u­lus pack­age has no bear­ing in the Chicago markets.

This is all not nearly as bad as it looks on paper. Chances of reces­sion are min­i­mal and, should one occur, it is likely to be short and timid. Despite oil and food costs being very high cur­rently, infla­tion through higher CPI, PPI and CPE is likely tem­po­rary and in no way rep­re­sen­ta­tive of the 1970’s cri­sis as some would indi­cate.  Jobs are reduc­ing to reflect the cur­rent slow­down, but still rel­a­tively strong.  In all probability, the reduc­tion in work­force will reflect the degree of reces­sion incurred…if such “R word” comes to fruition.  Cor­po­ra­tions are cash heavy right now and able to con­tinue for­ward even in slower eco­nomic con­di­tions.  If the hous­ing bust were to spi­ral com­pletely out of con­trol, leg­is­la­tors and the Fed will likely step in to for­mu­late the nec­es­sary solu­tion to ease a mas­sive cri­sis in hous­ing… should a cri­sis occur.  FHA would
likely be the solu­tion for sub-prime and over­tight­ened credit mar­kets of sorts.

Guys, this is absolutely the best time to pur­chase real estate in 20 years.  I pur­chased a 4 unit fore­clo­sure, 85% rehabbed and only mim­i­mal work needed for 2/3rds ($100K less) of cur­rent mar­ket value. There is an over­abun­dance of these types of deals out there.  How­ever, you will not find this kind of deal on new con­struc­tion or new con­ver­sion on the mar­ket.  Likely, you will pay within 10% of ask­ing and no less.  Devel­op­ers for large/new projects are rel­a­tively well cap­i­tal­ized and not going to give away prop­erty.  Those who are not well cap­i­tal­ized will ride out the mar­ket and get their price or foreclose.  It would be ridicu­lous to think they could or would sell at cost or a loss and, in their mind, may as well hold onto the prop­erty as long as pos­si­ble any­way if it were going to short sale or fore­clo­sure. The mort­gage mar­ket is a bit bumpy but can be nav­i­gated through with min­i­mal headaches should you retain an expe­ri­enced mort­gage plan­ner.  Under­stand how­ever, this is not the time to look for homes first, write a con­tract and go rate shop­ping.  There are just too many changes occur­ring weekly to trans­act in this fash­ion. Retain the pro­fes­sional, secure the financ­ing and the pur­chase or refi­nance trans­ac­tion will ulti­mately carry through smoothly for every­one.

Mort­gage Mar­ket — The Sub­prime Liq­uid­ity Credit Crunch 08/07

Prime vs. Subprime.pdf

The Bor­rower

Chicago, IL — Con­sumers inter­ested in pur­chas­ing or refi­nanc­ing a home will pay a given inter­est rate based on their per­sonal finan­cials, cur­rent mar­ket con­di­tions and product/debt strat­egy cho­sen. Risk assess­ment is based upon the borrower’s income and debt ratios, credit scor­ing and his­tory, liq­uid­ity and asset base, lever­age sce­nario and level of approval obtained which, cri­te­ria for the afore­men­tioned is tight­en­ing sig­nif­i­cantly by the day. If the borrower’s credit will not per­mit A+ lev­els of qual­i­fi­ca­tion — or if income and assets can­not be suf­fi­ciently doc­u­mented — an alter­nate course of lend­ing is needed. Unfor­tu­nately, this course of sub­prime and Alt A lend­ing has not been uti­lized in the way it was intended by the bor­rower and in some cases, the lender as well. Now we have issues. Start­ing from scratch, let’s take sub­prime for example -

Sce­nario — John and Jane Doe decide to pur­chase a home. In fact, they went home shop­ping first and nego­ti­ated a pur­chase agree­ment which is now fully exe­cuted and earnest money is on the line. Both bor­row­ers had not yet retained a pro­fes­sional mort­gage advi­sor and have been shop­ping around by tele­phone and the inter­net, which always incurs unre­li­a­bil­ity and inef­fi­ciency in the trans­ac­tion (but that is another story). John and Jane find me and agree to move for­ward. Upon a credit and finan­cial analy­sis, I dis­cover that both John and Jane have credit defi­cien­cies that will not per­mit a higher level approval (hence, lower cost) and also can­not doc­u­ment income due to tax return com­plex­i­ties. John and Jane also are just barely able to afford the home as 50% of their gross annual income is being uti­lized for the hous­ing pay­ment and per­sonal debt. They also have very lit­tle liq­uid assets (1 month hous­ing pay­ment) in reserve. They will need to uti­lize sub­prime or Alt A (alter­nate lend­ing) loan pro­grams in this case as it is the only viable solu­tion. Due to my dis­cov­ery, it would be advised that they get their earnest money back dur­ing the attor­ney review period, put the con­tract on hold and wait until a bet­ter for­mal plan of action is deter­mined by their mort­gage pro­fes­sional (me) and hard num­bers can be pro­vided. Most likely, a credit repair plan would be issued. By fol­low­ing the plan, the bor­row­ers would poten­tially have the abil­ity to qual­ify for A+ level paper within a 45 day time frame — which equates to a lower cost of funds (inter­est rate, etc.), more afford­able pay­ments and bet­ter terms all around. Rather, John and Jane want to move for­ward with the pur­chase instead of going through the credit repair plan (they may not have the time, $$ or some other rea­son). Now it becomes my job to uti­lize the best financ­ing option out of the very lim­ited options avail­able to get them into the home on time and STILL pre­pare them to uti­lize a credit cleanup action plan after clos­ing — which absolutely needs to be fol­lowed over the next 12–18 months. The only prod­uct for which John and Jane qual­ify is a 2 year sub­prime ARM (assume so for this exam­ple). Remem­ber, this is a 2 year sub­prime ARM loan. We only have 24 months to get every­thing in order for bet­ter financing.

We close. From there for­ward on a quar­terly basis, John and Jane are fol­lowed up with to deter­mine how much progress has been made on the credit repair. They respond with “no progress made.” Fur­ther advice is reit­er­ated as to what to do, how to do it and another set of instruc­tions and email are sent to the clients to be cer­tain they are on top of things. Another quar­ter goes by. Still no action. Another, and another and … all of a sud­den John and Jane are a month away from the ARM adjusting.

Well, we have arrived. Due to 1) the hous­ing mar­ket being in a slump (mostly, a state of stag­nancy with some areas sub­stan­tially in decline dur­ing the last 2 years) and 2) higher default rates on pre­cisely these types of loan prod­ucts from the pre­vi­ous two years, investors are no longer will­ing to extend credit loosely to this type of mort­gage financ­ing sit­u­a­tion. Now, we have two bor­row­ers who failed to fol­low a course of action to improve their credit over time; a hous­ing mar­ket pro­vid­ing no rate of return (appre­ci­a­tion) on the home they pur­chased; no equity in the home due to the lack of appre­ci­a­tion; no loan prod­ucts avail­able for highly lever­aged prop­erty with lit­tle equity (John and Jane’s sit­u­a­tion) due to the hous­ing and default rates over the last year and sub­se­quent guide­line tight­en­ing from investors — And a hous­ing pay­ment for John and Jane that will adjust the full 3% when the time comes, increas­ing their pay­ment by $600 per month with no oppor­tu­nity to refi­nance due to the pre­vi­ous con­di­tions men­tioned. Now the default cycle con­tin­ues. You can see where this is going.

The most frus­trat­ing aspect of a mort­gage planner’s pro­fes­sion is the inabil­ity to do any­thing for a client to rec­tify a poten­tially haz­ardous finan­cial pit­fall. A sit­u­a­tion such as this, which is based around sev­eral absolutely true sit­u­a­tions, is com­pletely out of our con­trol. The media and hype dis­cuss fraud and preda­tory lend­ing being the issue for prob­lem­atic mort­gage defaults. I have to tell you, this is absolutely not the case except in a very small per­cent­age of mort­gage loan fundings.

The Mar­ket

There are no issues with con­form­ing loans at this point. Sub­prime, Alt A and some non-conforming is the prob­lem area. Upon the street’s reassess­ment of the mort­gage mar­ket, the risk level has gone up sub­stan­tially due to higher default rates and stagnant/declining hous­ing over time…so a much higher yield is required on those loans to off­set the higher risk (based on the recent val­u­a­tion). Essen­tially the mort­gage bond is dis­counted (price deterioration/valued less) to the net present value which ends up dete­ri­o­rat­ing the bonds below a par yield. What was going to be a mort­gage sold to Wall Street at 101 now is being sold at 98 or 99 due to the deval­u­a­tion. It will now cost the mort­gage com­pany XX dol­lars per loan to fund the loan rather than mak­ing XX dol­lars in pre­mium from which it oth­er­wise would have profited…creating a total loss and deple­tion of the lender’s liq­uid assets to cover the dis­count. Sec­ondly, mar­gin calls (due to the dis­counted value of the mort­gages back­ing the assets) exor­bi­tantly height­ened this deple­tion sce­nario in which the nec­es­sary mar­gin short­ages required addi­tional liq­ui­da­tion of the mort­gage lender’s assets (it may or may not have had) to cover the min­i­mum main­te­nance require­ment or “ini­tial margin”.

In sum­mary, put the two together — Wall Street (the mar­ket) adjusted what it needed for com­pen­sa­tion — demand­ing a higher yield on funds already locked and being deliv­ered at a lower yield — cre­at­ing a total loss on each loan fund­ing within the next 30–60 days. Simul­ta­ne­ously, mar­gin calls added to the deple­tion of the company’s assets already being uti­lized to cover the deval­ued (dis­counted) mort­gage paper. Mort­gage com­pa­nies can­not go back to the con­sumer and ask for the higher yield to off­set this dif­fer­ence. Either the com­pany has the liq­uid­ity to weather the storm or it shuts its doors (think AHM) as the cost per day to stay open can be mil­lions of dol­lars in a credit cri­sis such as this.

One Day of busi­ness in a nor­mal credit market…100M in loans (in one day) going to sec­ondary @ 6.5% => 101M sell price => 1M profit in one day.

Today’s credit market…Wall street says 8% is the return needed for the addi­tional risk — which dis­counts the cur­rent loan to a net present value and COSTS the mort­gage com­pany. 100M in loans to sec­ondary at 6.5% => value is 97M => 3 Mil­lion Dol­lar loss in one day…not includ­ing mar­gin call coverage.

Two things need to happen:

1. The credit mar­ket needs to sta­bi­lize. It can­not con­tinue a cycle need­ing 8% this month to off­set the higher risk only to then need 9% next month and so on. Polls will iden­tify a given sta­bil­ity fig­ure and will even­tu­ally ease itself in the long term.
2. Loan pipelines need to be cov­ered. Clients need to get closed as soon as pos­si­ble. The mort­gage pro­fes­sional needs to have a cou­ple of backup plans just in case an overnight change occurs with an investor’s prod­uct ini­tially selected for that client which no longer becomes available.

Although the Fed has been step­ping in to pro­vide some relief to some parts of the sec­ondary mar­ket which have essen­tially seized, the bid/ask spreads will likely remain too wide for the MBS to trade; leav­ing lenders with large inven­to­ries and fac­ing addi­tional mar­gin calls. In my opin­ion, if the Fed steps in to add liq­uid­ity and help sta­bi­lize the credit mar­kets — by their own admis­sion — this greas­ing of the cog wheels will be “lim­ited” in the over­all effect. If they are able to move the sec­ondary mar­kets a bit, it will only flush out the already fun­da­men­tally unde­sir­able port­fo­lios. Since most high-leveraging, alter­nate doc­u­men­ta­tion sub­prime lend­ing has ceased, a Fed move will mostly affect only mar­ket port­fo­lios already ware­housed. Those loans that that were orig­i­nated at 102… and now need­ing to fetch 103 or 104 on the street… might be offered at 98 to 100 only nar­row­ing the spread and lim­it­ing the lenders net losses — but not sav­ing them entirely. Even then, only the strongest banks (with large amounts of cash on hand) will be able to weather the storm after the Fed’s assis­tance. Aggres­sive investors will still be needed to move behind the fed to uphold any momen­tum the fed ini­ti­ates and pull through the mar­ket dete­ri­o­ra­tion within a rea­son­able time frame.

Rec­om­men­da­tion — CLOSE YOUR LOAN AS SOON AS POSSIBLE!

Under­stand­ing the Role of the Fed in Today’s Credit Crisis

With all the head­lines scream­ing Credit Cri­sis! and Mort­gage Melt­down!, it can be dis­heart­en­ing to think that the appar­ently smart peo­ple serv­ing on the Fed­eral Reserve Board think that the answer to all of this would be to lower a “largely sym­bolic” inter­est rate called the “dis­count rate.”  After all, any rea­son­able per­son would think that if there really is a credit cri­sis, the Fed should do away with “sym­bolic” ges­tures and start DOING some­thing for good­ness sake!  Right?  Well… the Fed IS doing some­thing; we just need under­stand WHAT they are doing.

In order to under­stand the cur­rent credit cri­sis, please ref­er­ence the arti­cle above.  Assum­ing you have read that arti­cle, you know that we are cur­rently fac­ing a “run on the mort­gage banks” by the Wall Street investors and ware­house lenders who pro­vide fund­ing for US mort­gage loans.  Well, the Fed has looked at this sit­u­a­tion and basi­cally said, “Hmmmm, we bet­ter pro­vide these finan­cial insti­tu­tions with a new source of short term fund­ing so that they can con­tinue to oper­ate even dur­ing this liq­uid­ity crunch.”

The Fed can pro­vide fund­ing in four ways:

1. Open mar­ket activ­i­ties – this would be where the Fed injects cash into the bank­ing sys­tem by pur­chas­ing the Trea­sury secu­ri­ties held by var­i­ous banks and finan­cial insti­tu­tions. This allows the finan­cial insti­tu­tions to use this cash to meet their liq­uid­ity needs.
2. Lend­ing money directly to the banks that are part of the Fed­eral Reserve Sys­tem through what is called the “dis­count win­dow”
3. Reg­u­lat­ing the inter­est rates that banks charge each other
4. Reg­u­lat­ing the amount of reserves that banks are required to main­tain in order to operate.

The Fed has done quite a bit of open mar­ket activ­ity in recent weeks, and that hasn’t quite fixed the credit cri­sis prob­lem.  So, on Fri­day, August 17, the Fed low­ered the “Dis­count Rate” from 6.25% to 5.75%.  This is the inter­est rate that banks pay when they bor­row money directly from the Fed.  Sounds sim­ple enough!  How­ever, why are peo­ple say­ing that this is largely a “sym­bolic” move?  Also, what affect will this really have on the cur­rent “credit cri­sis”?

In order to answer these ques­tions, it is help­ful to under­stand the four major inter­est rates that are affected by the Fed:

1.  Dis­count Rate (cur­rently 5.75%)- the inter­est rate that banks pay when they bor­row money directly from the Fed.  The rea­son this is largely sym­bolic is because hardly any banks take the Fed up on their offer these days!  You see, banks pre­fer to get short term financ­ing by:

• Issu­ing “com­mer­cial paper” – these are short term IOUs of typ­i­cally one to sixty days that are sold on the open mar­ket to Wall Street investors.  Inter­est rates on these short term loans are often bet­ter than the dis­count rate offered by the Fed bor­row­ing money from other finan­cial insti­tu­tions using the Fed Funds Rate as illus­trated below.
• Bor­row­ing money from other finan­cial insti­tu­tions using the Fed Funds Rate as
  illus­trated below.  In most cases, Fed Funds rate is also bet­ter than the dis­count
  rate offered by the Fed.  

2.  The Fed Funds Rate (cur­rently 5.25%) — the inter­est rate that banks pay when they bor­row money from each other here in the US. This rate is also deter­mined by the Fed because banks in the US are part of the Fed­eral Reserve Sys­tem. You see, 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.

3.  LIBOR Rate (1 month LIBOR is cur­rently 5.6%) – 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 their 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 inter­na­tion­ally these days.

4.  The Prime Rate (cur­rently 8.25%) – the Fed Funds Rate + 3; this is the base rate that is 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 cur­rent credit cri­sis, the Fed has done some open mar­ket activ­i­ties and they have low­ered the dis­count rate. How­ever, more action is prob­a­bly needed.  In the com­ing days and weeks, the Fed is prob­a­bly likely to:

• Con­tinue low­er­ing the dis­count rate as nec­es­sary to make it more attrac­tive for banks to take advan­tage of that win­dow of oppor­tu­nity (no pun intended)
• Lower the Fed Funds Rate as long as infla­tion remains under control.

You see, if the Fed low­ers the Fed Funds Rate, the busi­ness and consumer-based inter­est rates of LIBOR and Prime will also go down as illus­trated above. The Fed would be reluc­tant to do this if they feel that busi­nesses and con­sumers would start bor­row­ing and spend­ing so much money that infla­tion will go up significantly.

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 of them 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, how­ever, is that in some of their most recent state­ments, the Fed has said that infla­tion is basi­cally under con­trol. They have seemed to indi­cate that they are start­ing to get more con­cerned about other threats to mon­e­tary sta­bil­ity – such as the cur­rent credit cri­sis fac­ing the econ­omy. In fact, accord­ing to the lat­est read­ing, the Fed’s favorite mea­sure of infla­tion was only run­ning at an annual rate of 1.9% com­pared to over 2% in recent months. This is below the implied infla­tion “dan­ger zone” and seems to indi­cate that the Fed may be more likely to lower the Fed Funds Rate mov­ing forward.