Discount Rate vs. Fed Funds: What does it mean to you?

The Federal Reserve has taken significant action in the last few weeks due to the credit crunch. And now they've made an unexpected move by cutting the discount window rate, which is great news. We'll get to that in a minute, but first let's look at recent events and understand what they mean.

To date, over 120 mortgage companies have closed their doors due to reduced liquidity. The result: borrowers who want to take out non-conforming loans have fewer, more expensive options.

Many media outlets have incorrectly added fuel to the fire by stating mortgage lending has stopped altogether and borrowers can't get a loan without a 20% down-payment. This is not true.

Conforming interest rates and loan programs, those backed by Fannie Mae and Freddie Mac, have not been significantly impacted by recent events. Even better, interest rates have come down from recent highs. While this is good news, the market is experiencing unprecedented volatility and changes could come at any time. Borrowers need to act swiftly and decisively in today's climate.

What did the Fed do?

Now back to the discount rate. This is the interest rate charged to commercial banks and other depository institutions on the loans they receive from their regional Federal Reserve Bank's lending facility. The Fed's decision to cut this rate provides stability in the financial markets and this can be good for all of us.

How exactly does this provide stability? Here's an example: imagine you just wrecked your car and it requires $5,000 worth of repairs. You have a short-term need for cash to pay your mechanic. Even though you know you will eventually be reimbursed by your insurance company, you still need the cash now. So, do you sell off stocks to get the cash, or tap into an equity line of credit? Most likely, you draw from that line of credit rather than liquidating a long-term investment.

This is what the banks are facing in today's liquidity crisis. And Bernanke's move helps them avoid long-term damage by supplying access to short-term cash.

It's important to note the discount rate is different than the Fed Funds Rate, which directly impacts interest rates you pay for Home Equity Lines of Credit, credit cards, and automobile loans. Most importantly, the discount window rate cut does not directly impact home loan rates.

"THERE AIN'T NO CURE FOR THE SUMMERTIME BLUES..." Eddie Cochran And although Bernanke and the Fed can't do much to help you overcome the feeling of summer slipping away - their actions have helped to stabilize the financial markets, and calm some of the "credit crunch blues". Just over a week ago, the Fed made a decision to lower the rate at their "Discount Window", allowing banking institutions another method of providing assurance of liquidity to their clients, and also helping many institutions continue to fund home loans. Due to the Fed's action, the past week was somewhat calm in the financial world...at least calmer than has been seen in awhile. Both the Stock market and the Bond markets moved higher, and conforming loan rates remained stable to very slightly improved.

Further, some decent news arrived on the housing front via the New Home Sales report, showing a 2.8% increase in sales for July, and an upward revision to June's numbers as well. Unsold new home inventory continued to decline for the fourth consecutive month, falling by 1.0% to 533,000 homes. This inventory represents a 7.5 month supply, down from the 7.7 month supply in June. Additionally, the median new home sales prices edged higher to $239,500. Not bad news overall, particularly considering the current landscape in the lending industry.

Looking ahead, it appears that Bonds will have dual challenges of "fundamentals" and "technicals" to overcome if loan rates are to see much improvement in the coming week.

"Fundamentals" are the news items and reports which can influence Bonds and home loan rates. In general, hot or positive economic news tends to help Stock prices get better, but causes Bonds and home loan rates to worsen - and vice versa. This week, there will be a slew of potentially high impact reports in store, ending with a very important read on inflation by way of the Core Personal Consumption Expenditure Price Index (PCE). Should this read on consumer inflation come in hot, showing inflation on the rise - Bond prices and home loan rates may worsen. But if the reading shows inflation to be controlled and moderating, Bonds and home loan rates may improve.

But then there are the "technical" factors to contend with too, although they tend to take a back seat to important economic reports and news. One part of technical analysis means looking at where Bonds are trading now, versus where they have in the past, and thinking about what patterns are likely to repeat themselves. Remember that when Bond prices move higher, home loan rates move lower.

Overall, it has been very hard to price loans for clients in the last few weeks and few lenders will agree to an upfront rate lock, preferring to float the loan up 'till closing.

Basically, lenders are looking for quality loans, not even the slightest bit of trouble, and are pricing accordingly.

Rate Differences By Property Type: Auto Repair Facility

Auto Repair facility on a land contract (a form of seller financing where the seller holds the mortgage) at 10%, looking to refinance to lower the rate. Nothing fancy.

Interest rates and terms vary by property type. For example, a multifamily property will get the higher loan-to-values and the best interest rates because it is a simple income property to size up and very marketable.

The further removed a property type is from a simple, income-producing property, the more expensive the loan terms.

So an auto repair facility, even if very clean, will require a slight rate premium.

This is why commercial borrowers must be reasonable in their search for interest rate, because plenty of lenders will lowball the rate to "take the deal off the street" only to give up the real terms once the third-party fees are in the door.

Explaining Fed's Friday move on Discount Rate vs. Fed Funds Rate

"A day may sink or save a realm" said Lord Alfred Tennyson, and indeed, many saw Friday morning's surprise action by the Fed as a move that saved the day in terms of the financial markets...at least for now. What was the surprise move exactly? It was actually a doubly good surprise, consisting of two specific actions by the Fed, designed to help ease some of the current fears in the financial markets.

First, a .50% cut to the Discount Rate, taking it from 6.25% down to 5.75%. This is the rate at which the Fed lends money directly to commercial banks, credit unions, savings & loans, and also including large mortgage bankers.

Now this is a different rate than the Fed Funds Rate - which is the rate at which banks lend money to other banks, currently at 5.25% - and is the rate generally discussed in terms of cuts or hikes surrounding normally scheduled Fed meetings. Note, the Fed's move to cut the Discount Rate has no impact on mortgage rates or consumer rates like home equity lines of credit.

The Discount Rate is generally above the Fed Funds Rate, which does make borrowing money from the Fed a last resort for lending institutions, as they would generally borrow from other banks at a lower rate. However, with the current liquidity situation making that more difficult by the day, the Fed's move will help provide lending institutions more liquidity at more desirable rates in the short term.

Next, the Fed extended the borrowing period on these funds from overnight to thirty days - which could allow some lenders to use this money for funding home loans, in case their other sources are backing off.

It will also allow time for the credit markets overall to settle out a bit, and this move will help financial institutions better weather the current storm. In fact, Stocks loved the news - particularly financial stocks - and the Stock market rocketed higher on the good news. Bonds and conforming home loan rates were volatile throughout the week, but ended up unchanged to slightly improved overall.

The Best Explanation of How the Mortgage Meltdown Happened

What is the "subprime meltdown"?

How does it affect individuals?

Here is a link to a very well-written article in layman's terms which explains the entire credit market mess.

Sloppy mortgage people and companies

I wrote my first mortgage loan in 1986, and have seen a lot of ups and downs.

The last few years have been out of control. One could just see it in the sloppy ways loans were originated and underwritten.

There are only few States in this country that require that the actual loan officer be licensed or accredited in any manner. Consequently the least qualified people are advising homeowners on the largest dollar purchase of their life. And don't forgive the bank or mortgage banker loan officers - they can be just as incompetent. Its amazing that a dog needs a license but a loan officer doesn't.

Then the lender underwriting standards have been basically non-existent. For 20 years I've known an honest and credible underwriter, an expert in FHA and VA underwriting, who has had to sit next to new hires with no mortgage experience who are supposedly "underwriters" going through a checklist.

And what about quality underwriting? Out the window when the boss comes in and says "I can get 105 on the street right now for these loans. Approve them!" (105 means getting paid 5 points or 5 % of the loan amount). What is an underwriter to do but just sign off?

And what about the lenders creating the absurd qualification guidelines that permit "pushed" appraisals, "stated" income and assets, and basically lend on a credit score and borrower (or loan officer) lies?

And what about the market that is willing to buy those loans, split them into many parts and sell the risk to investors? As long as there's a buck to be made, quality underwriting doesn't really matter

And what about the homeowners who basically have financed the last six years economic expansion through trading short-term credit card debt for long-term mortgage debt to lower monthly debt service, and open up more credit card balances for more silly purchases? They're paying the price now: No more credit available, no increasing home values, no free cash-flow for dining out, no opportunity to sell out for a profit.

When the mortgage industry thrives on less than creditworthy standards, it is only a matter of time until the chickens come home to roost.

Thinking of personal & national state of financial affairs

Subprime mortgage meltdown, non-existent personal savings rate, and the U.S. as a creditor nation.

This is the perfect storm for disastrous financial consequences, both in one's personal affairs and for the national interests.

It was serendipitous that I came across three different articles that all related to the same essential issue: Financially, things are going to get pretty bad.

First, an editiorial in the New York Times decried the Fed's lack of ability to maneuver due to the country's need to borrow to finance trade imbalances, and the inept weakening of the dollar as a temporary knee-jerk response, when what is really needed is a decent savings rate.

Second, combine that problem with a British article on China's threat to sell-off U.S. dollars as a response to U.S. threats to impose trade sanctions if China does not weaken the yen.

With dramatic negative results, such an action by China would spike bond rates and make commercial and residential borrowing very expensive, crunching cash-flow and restricting needed credit that is keeping the economy going.

Third, Pat Buchanen happens to wrap the entire issue up nicely in his latest article in Human Events appropriately entitled "Subprime Superpower." Clearly the poor financial state of U.S. affairs prohibits rebuilding bridges and roads, improving the electrical grid and other infrastructure, supporting the minimum current military needs while threatening huge and unaffordable actions elsewhere along with huge entitlements.

As he says, "who are we kidding?"

Since I started lending in 1986, I've been through the downturns in 1987, 1990, 1994, 1997, 2000, and now the biggest in 2007. This is about as bad as I've seen it because loaned money has been so easy to obtain that the American consumer has not given any thought to personal savings, or even a back-up plan to meet cash-flow needs should something go wrong.

It appears that in the near future credit will be expensive, if even available. The huge amount of foreclosures now hitting the books and the increasing delinquencies in mortgage portfolios are merely the tip of the iceberg. It will take a few years for this to get through the system and until then lenders will tighten up underwriting.

The people that will survive and maybe prosper in this environment are those that have saved for this "rainy day," been conservative in their borrowing, and are diligently working at paying down credit.

Perhaps the current generation will learn from this latest disaster to begin saving as a personal hedge against national or global financial meltdowns.

Name Popularity

A little off-topic here, but in marketing my website and commercial mortgage services, I find it interesting how many people will use my given name "Alfred" compared to those that automatically shorten it to "Al."

Is there something frightening about the name "Alfred"?

The meaning behind the name is 'counselor' which suits me just fine in my current occupation.

But the history of the name has gone from somewhat popular in the late 1800s, to a little awkward since the gap-toothed Alfred E. Newman from Mad Magazine hit the scene shortly after I was born.

How popular has your name been throughout the last 126 years? Go to this website and let your mouse-pointer find your name or type in your name to see its popularity history.

"Walk away from your home" per Jim Cramer

What is your opinion on the controversial viewpoint of Jim Cramer, advising people to walk away from their home and default on their mortgage if the home value declines?