Interest Rate Roundup

Friday, August 17, 2007

More thoughts on the Fed move...

Boy, can things change quickly in this market. Yesterday at midday, it looked like financial Armageddon. Then the stock market reversed and almost closed in the green. And then this morning, as I mentioned earlier, the Federal Reserve swooped in and agreed to cut the so-called “discount rate” by half a percentage point, or 50 basis points, to 5.75%.

What’s the discount rate? It’s a rate charged on short-term loans that banks can take out directly from the Fed. The discount window is perceived as essentially a “last ditch” place for regulated institutions to borrow in times of crisis. The move is an attempt to calm the recent panic in the financial markets. The Fed did NOT cut the more widely followed federal funds target rate. It remains at 5.25%.

So what does it all "mean?" Well, we are still in the midst of a financial crisis brought about by the housing and mortgage market meltdown. This Fed move will clearly drive the price of financial shares higher in the short-term. The question is: What happens when the short-term, violent market moves settle down?

Here's my thinking on the matter: This discount rate move is a stop-gap measure that won’t suddenly make mortgages perform better. It won’t eliminate the gigantic overhang of homes for sale. And it won’t prevent banks and lenders from taking big losses on delinquent home loans. It could restore some confidence in the banking system ... or it could make people ask whether it's a sign of "panic" (i.e. is the Fed cutting rates because it knows something we don't?)

Longer-term, if the Fed move is followed by further mortgage bailout-type programs, perhaps from Fannie Mae and Freddie Mac, and/or followed up by actual funds rate cuts, then it might have a bigger impact on the housing and mortgage markets. For now, though, conditions remain very weak.

To whit: Existing home sales have dropped about 20% from their peak, while new home sales have declined 40%. The inventory of homes for sale is sky-high. A home builder optimism index has fallen to its lowest level since 1991. And a measure of home construction activity has fallen to a 10-year low.


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