WeeklyBasis 08/20/07: Ride The Storm

Another stormy market week ended Friday with the Fed cutting the Discount Rate by .5%. This week begins with Capital One’s Greenpoint Mortgage closing their doors and laying off 430 workers in Marin County. My full respect and support goes out to those professionals as we all ride this storm. Once again, I am extending WeeklyBasis beyond the 2 paragraph briefing to give emphasize points that may be getting lost in the barrage of Credit Crunch press coverage.

The Discount Rate cut enables banks to borrow short-term Fed funds at 5.75%. Normally Fed Discount Rate loans are only used in a pinch because there’s cheaper financing elsewhere. But most global warehouse banks won’t or can’t offer cheaper loans to other banks right now, so the Fed stepped in. This means banks can use short-term Fed money to keep funding new debt such as mortgages.

This does not mean the Fed is rewarding bad decisions. The Discount Rate cut contains panic and (hopefully) helps reignite credit markets, but tighter lending guidelines still flush out companies and people who take too much risk. A homebuyer with 600 credit and no cash won’t get loan right now, and neither will a hedge fund seeking short-term money to fund high-risk investments.

The Fed’s Discount Rate cut plus their infusion of about $80 billion into the banking system has prevented an all-out market meltdown, but results are muted so far because there’s still a lot of bad mortgage and investment debt in the financial system. It will take months and possibly years for this to unwind – with more volatility and more company closures.

Meanwhile, new mortgage originations based on tighter approval standards should create a new wave of good quality Jumbo loans above $417k that investors will buy, and securitize or hold. But rebuilding a robust mortgage securities market could take years because tighter guidelines will cut down the pool of eligible borrowers, and nobody knows just how much bad debt is in the system.

This is why consumer rates eventually have to come down, to help offset tighter loan guidelines. The consumer accounts for two-thirds of the economy, and if they go down, they take the ship with them. The Fed can help matters using the Fed Funds Rate, which has a more direct impact on consumer rates than the Discount Rate. Markets are currently pricing in .375% in Fed Funds rate cuts by the Fed’s September 18 meeting, and .75% in cuts by the end of this year.

This would bolster the consumer but remember: the Fed can help, but their policy tools can’t directly bail out consumers. That’s why they started with the Discount Rate cut and the cash infusions. If that doesn’t work, then the Fed Funds rate cuts will come. It won’t fix everything, but it may help Jumbo loan markets to re-price back to market levels (right now they’re being priced based on risk, not on market levels). But again, it’s a matter of when. That could take a year or three years or more.

Home buyers, like any investors, often get nervous when markets are stormy. But this is the time to really pay attention. Higher mortgage rates and constrained loan markets mean lower property prices, and as I illustrated in my most recent client newsletter, the financial benefit of a lower purchase prices far outweighs the higher rate.

The math on this theory overwhelmingly proves the case in short- and long-term scenarios. It will become more important to use this formula for evaluating decisions in the coming months. If you need a copy of this article or need to have me run an example for you, please let me know.

Conforming ($200,000 – $417,000) – NO POINTS
30 Year: 6.5% (6.64% APR)
5/1 ARM: 6.75% (6.89% APR)

Jumbo ($417,001 – $650,000) – NO POINTS
30 Year: 7.625% (7.765% APR)
5/1 ARM: 7.5% (7.64% APR)