The much anticipated day has
finally arrived, September 18th, when the Fed made the decision to cut the federal-funds target
rate by 50 basis points as well as the discount rate by 50 basis points. The move was a bit stronger then
expected. What has led to this? Why has this been somewhat expected and
deemed necessary? The summer of 2007 is
one that nobody in the mortgage industry will forget. Firms shut down literally overnight, locks
were not honored, and rates increased dramatically.
I witnessed this first hand after attending a seminar put on by ABC, American Brokers Conduit, a conduit for American Home Mortgage, at which Greg Frost was speaking. It was a great seminar and very informative, I walked out with greater knowledge of how to increase business and, of course, a few ABC knick-knacks they handed out. Only 2 weeks later they shut their doors practically overnight, no loans in our pipeline could go through ABC anymore. I still have the leather planner with the ABC logo they gave me at the seminar, always to remind me of the mortgage industry troubles I experienced first hand this summer.
What has been deemed the ‘liquidation crisis,’ or ‘subprime meltdown’ in the US, reached a global level this summer. It began as a Wall Street risk adjustment for subprime loans as they were determined to be highly risky because of increased default risk. Government banks were forced to inject billions of dollars into economies to ease the worry of tight credit. Also, the Fed ‘opened the discount window’ for the first time since September 11th, 2001, that is how serious this credit problem became. So exactly 6 years and 1 week after the events of September 11th spurred a recession, the Fed has deemed the worsened economy worthy of a bold 50 basis point rate cut. This proves an interesting comparison attesting to cyclical economies.
But what actually caused the ‘subprime meltdown?’ In reality it can be traced back to the booming housing markets. These markets were saturated with mortgage brokers who did not know their trade. People were being placed in high risk loans, option ARMs, Neg Ams, and loan amounts above what their income should allow. Many borrowers were not aware that their payments may jump dramatically in future years. However, at the time there were no problems because homes were appreciating at a greater rate than people’s principal or interest payments were increasing. While things were good, almost anyone could get the loan they wanted, until most recently home appreciation slowed or even declined short term in some markets. The decrease in home equity caused a higher risk to those subprime borrowers as they ultimately began defaulting. This is were the default risk adjustment was made by Wall Street, or the mortgaged backed securities, as they realized the increased risk from these subprime loans.
Now that the underbelly of the ‘liquidation crisis’ is revealed, the Fed’s actions can be analyzed as one of the ways in which they seek to monetarily control the economy. All of ‘opening the discount window,’ lowering the federal funds target rate, and buying or selling treasuries are three ways in which the Fed uses its controls. This summer all three were enacted, lastly with the reduction of the federal funds target rate. The action, contrary to a standard misconception, is just a target that the Fed seeks to achieve and not an actual rate that they lower. However, this action will hopefully ease this tight credit market and enable businesses to gain currency easier and be more liquid. So did the Fed make a good decision? In my opinion they made a necessary decision in order to help the troubled credit market and the slipping economy. I believe that in the future things will still continue to economically decline, particularly the value of the dollar, which is continuing to slip. However, the strong global economy will actually help the
By, Joe Brady