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Feds and Rates

Monday, February 22, 2010 - Article by: Lender411 Member

Certainly you have heard from others about the Fed's move to increase their discount rate last week. We won't bore with the action but perhaps a quick explanation of why the Fed would adjust their rates and the impact. A weak or slow economy is characterized by low borrowing by businesses and consumers. Spending from both entities tends to mirror the borrowing practices of both. A down economy is fueled when both the business and consumer segments began to spend. The Fed cannot control spending, but in an effort to increase borrowing, thereby increase spending, they will lower the rates they control. Conversely when an economy is expanding the Fed will increase their rates to control the poison of inflation. Now here is the interesting and important part....once a down economy turns the corner, the Fed may increase their rates to keep consumer interest rates low by suppressing inflation before it happens. It is important to note that the action this week involved the Federal Reserve discount rate which is the rate banks pay to borrow money from the Fed (as a last resort) and does not directly affect the consumer. The Fed reiterated their intention to keep the Federal funds rate which does ultimately impact a wide range of interest rates low for an extended period; however this week's Fed move serves notice that 'an extended period' does not mean forever. Market Update: The week began with all eyes on Greece and China for reasons discussed last week, however by Wednesday the Federal Reserve had stolen the spotlight with news unfavorable to the mortgage market. The unexpected news pushed rates higher and faster at a pace we have not experienced lately. It goes without saying; the Fed has been the single most influential factor on low mortgage rates for over a year by purchasing greater than $1 trillion of Mortgage Backed Securities. Wednesday in a speech before the World Affairs Counsel Philadelphia Federal Reserve Bank President Charles Plosser outlined the Fed's need to normalize its balance sheet "sooner rather than later" by selling parts of its now extensive Mortgage Backed Securities portfolio and end the practice of purchasing MBS. Later in the day, the Fed released the detailed minutes from its January 27th meeting which revealed several other officials of the policy board favoring selling the MBS in the near term. The news caught the markets by surprise as investors were expecting the Fed to hold the MBS for a longer period. Why does this matter? Simply put supply and demand. A certain percentage of invested money flows into the U.S. Mortgage Backed Securities market daily by investors from around the world. The investors may hold the MBS as a long term guaranteed yield investment or short term safety net bringing the MBS back to the market as a resale at a later date. In a normalized market, the vast majority of daily MBS purchases on Wall Street are new securities (recently funded loans). The resale of large volumes of MBS adds to the supply but the demand doesn't change. When supply is greater than the demand, sellers must increase the yield (interest rate) to attract additional investors or greater involvement from current investors. We knew it was coming, just maybe not this quickly. While some of this week's interest rate increases may show to be an overreaction with an adjustment to soon follow, prospective buyers should note the tip of the rate volatility iceberg expected this year. Floating an interest rate in 2010 could risk not only with the rate but loan approval. Sellers should ask for loan commitments to address if the buyers have locked a rate or the maximum qualifying rate.

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