The big news this week was Tuesday’s Fed meeting. As expected, the Fed held the Fed Funds rate at 2.0%, but investors were concerned with the tone of the accompanying statement. The Fed’s challenge is to balance the risk of slower economic growth with the threat of higher inflation. Overall, the statement indicated that the Fed is more concerned with stabilizing the financial system than with fighting inflation. This, combined with Monday’s higher than expected reading on core PCE inflation, led to a small increase in mortgage rates during the week.

The European Central Bank (ECB) also held a policy meeting this week, and they, too, made no change in interest rates. ECB President Trichet’s comments were similar to Bernanke’s, with warnings about the risks of both slower economic growth and higher inflation in Europe. The economic performance of other countries is important for US mortgage markets, since foreign investors purchase a large quantity of US bonds. For example, foreign investors accounted for 43% of the 30-yr issue and 34% of the 10-yr issue in this week’s Treasury auctions.

In the housing sector, the June Pending Home Sales index rose 5% from May. Pending Home Sales are a leading indicator of future housing market activity, so the next Existing and New Home Sales reports may show increases. In addition, the chief economist of the National Association of Realtors (NAR) expects the recently passed Housing Bill to stimulate the housing market later in the year.

Anyone watching or reading the financial news over the last few weeks has seen a lot of angst and consternation over the state of the mortgage industry. In fact, one of the larger lenders in the US, American Home Mortgage, was forced to shut down operations recently. But why? What is happening, what does all this mean to you and most importantly… what should you be doing do right now to make sure you are protected?
Here’s the scoop.
Over the past several years, many loans were made to homeowners with somewhat non-traditional or “non-conforming” situations, be it a poor credit history, inability to document income, or any number of factors that do not fit within the traditional “box” for home loans. These loans are often called “Sub-Prime”, or “Alt-A”, meaning that they were somewhat riskier in nature than A credit, prime, or traditional loans. Another type of “non-conforming” home loan is one where the credit and income might be perfectly fine, but the loan amount is higher than $417K, which is the current maximum loan that can be done using pools of money from mortgage giants Fannie Mae (FNMA) and Freddie Mac (FHLMC). If the loan amount is higher, it can certainly be done - it’s called a “jumbo loan” - but the end

When Alan Greenspan says that Adjustable Rate Mortgage (ARM) loans were a better choice than fixed rate mortgages, people start to pay attention. So if ARM loans could have saved homeowners very significant amounts of money, why have Fixed-Rate products been the overwhelming favorite? The answer could be in the borrower’s lack of understanding, experience, or perhaps it is unjustified fear.
Additionally, many loan professionals may not have adequately and articulately walked their customers through the pros and cons of an ARM loan. Once a borrower gains a better understanding of the proper way to make comparisons between loans that can adjust vs. those that are fixed, as well as the historical data, they may be much more open to selecting an ARM loan and reaping the benefits.

There are lots of ARM loans to choose from and the features can vary quite a bit. The time that an ARM will remain fixed before adjusting and the factors governing the future adjustments, including the maximum amount the rate can change are important points to consider.
The future adjustments are based on an index, so understanding what will cause the index to fluctuate as well as historical data on the index are both important to know. Let’s look at one popular type of ARM…a 5/1. This loan will remain fixed for the first five years but then adjust every year thereafter. A common misunderstanding that many consumers will have is that they feel they should only consider the
5/1 ARM if they plan to be in their home for five years or less. They often fail to recognize that the savings made in the first five years will offset future years of possible higher payments if the rate on the ARM increases. The best way to illustrate this is to look at a specific example. It is very common for the rate of a 5/1 ARM to be about 1% lower that the rate on a 30-year fixed loan. Assume the loan amount were $300,000. The 1% savings on the 5/1 ARM would save the borrower about $200 each month for the first 60 months (5 years). That would net them a hefty savings of $12,000 during that time. But most borrowers worry about what will happen after the initial period. If the $12,000 savings during the initial five years were just placed in a piggy bank, there would be enough funds there to draw upon to cover future worst case increases for the following 2-3 years. This assures the borrower of coming out ahead by selecting the 5/1 ARM for 7-8 years. Compare that to the average life of a mortgage loan, which is four years (because people will refinance or sell their home) and the odds become stacked in your favor that the ARM will save you money.

Let’s Get Creative
Another strategy that can be used for the above mentioned example is to take the $200 monthly savings and use it to reduce the balance on the mortgage. The pre-payment of principal will have an even greater effect because the borrower is now skipping down the amortization schedule and paying more principal and less interest on each subsequent payment. After the initial 60 payments made during the first five years, the borrower would have approximately $17,000 more equity in their home because of the reduced principal balance. Because the borrower has this extra $17,000 in equity, they would be better off with their 5/1 ARM for approximately 10 full years. This is true if rates moved higher after the initial five years…even in the worst-case rising rate scenario. And, it just so happens that the National Association of Realtors states that the average period of time that people sell their residence is every 10 years.

Another benefit when using the strategy of reducing the principal balance happens at the time of the initial adjustment. When an ARM loan adjusts, it essentially becomes a new loan where the payments are based upon the remaining years, the new interest rate and the remaining balance. Because the remaining balance is significantly lower when the savings are used to reduce principal, the payment can actually go down even if the interest rate adjusts higher.

I Am Not a Gambler
Many borrowers say they refuse to take a gamble on their selection of a mortgage product so they stick with a fixed rate. Well, like it or not, what ever their choice is, it’s a gamble. Selecting a fixed rate still means they are betting that, during the time they are obligated to pay the mortgage, the fixed will perform better than the ARM.
Either way, they are rolling the dice and making a bet. The only difference is they will know the result of the fixed payment. The key here is to get the odds to work in your favor. That is where understanding and guidance from the loan originator can be worth its weight in gold.

Back to The Future
They say a picture is worth a thousand words. The chart below may be worth thousands of dollars. Over the past 200-years, interest rates on the US 10-year Treasury Note have, for the most part, remained fairly tame. The average has been close to 6%, but many fear the chance of runaway double-digit rates. Rates have remained in the single digits for all except 8 of the 214 years shown below. The rampant inflation of the late 1970’s had to be reigned in. So rates were pushed higher during the 1980’s. The result…low inflation and rates over the years leading to the present time. The lesson learned by the Fed was to use an ounce of prevention instead of a pound of cure. In other words, the Fed acts quickly now to hike rates a little so that inflation will remain in check, which helps keep rates from running significantly higher. The sky-high rates of the early 1980’s will probably never be seen again.

The Federal Reserve has been on a rate cutting spree once more. Many mortgage applicants are calling their mortgage representative and expecting a lower interest rate. Others who have been waiting to refinance are puzzled as to why mortgage rates have not moved lower during the recent five Fed rate cuts. This is difficult to explain to consumers who have watched a 2.25% reduction by the Fed with very little benefit in mortgage rates.

Is a Fed rate cut really good news for mortgage rates? The facts may be surprising. The Fed can only control the Discount Rate and the Fed Funds Rate. This is very different from mortgage rates. A mortgage rate can be in effect for 30-years while a rate set by the Fed can change from one day to another.

It is often said history repeats itself. And if history is any teacher, we can learn from what happened to mortgage rates the last time the Federal Reserve was in a rate-cutting cycle.

The last time the Fed was in a lengthy rate cutting cycle was back in
2001 from January 3, 2001 to December 11, 2001. In the span of 11 months, they cut the Fed Funds rate 11 times with eight of those cuts by 50bp. This resulted in a total of 475bp or 4.75% in short-term interest rate cuts taking the Fed Funds Rate from 6.00% down to 1.75%.
Now most uninformed people would naturally think because the Fed cut rates by so much during this time that mortgage rates would follow suit and trend lower as well. Not so. Mortgage rates actually moved higher during this time of significant rate cuts because inflation, the arch enemy of bonds, gradually rose.

Now let’s take a look at what happened with the Fed’s most recent cutting cycle, the first since 2001. On September 18, 2007 the Fed cut the Fed Funds Rate by 50bp. The mortgage bond market briefly enjoyed a “knee-jerk” reaction to the Fed move by closing higher that day, but lost 140bp over the following two sessions. Then on October 31, 2007 the Fed lowered the Fed Funds rate by 25bp. The mortgage bond market responded by losing 78bp over the following five trading days. On December 11, 2007 the Fed once again lowered rates by 25bp and the mortgage bond market lost 88bp in the next three days. So far this year, the Fed delivered a surprise 75bp rate cut on January 22, 2008 and mortgage bonds lost a whopping 144bp in just 2 days. Eight days later and as widely expected, the Fed cut rates by 50bp. Within 13 days from that 50bp cut, mortgage bonds lost 269bp.

Consumer loan delinquencies reached their highest levels since 1992 as the weakening economy continued to takes its toll on the American public, the American Bankers Association said today.

According to the group’s Consumer Credit Delinquency Bulletin released today, the composite ratio, which tracks eight closed-end installment loan categories, climbed 21 basis points to a seasonally adjusted 2.65 percent in the fourth quarter.

All eight categories experienced a rise in delinquencies during the quarter, which are characterized as late payments 30 days or more overdue.

Home equity loan delinquencies increased to 2.39 percent from 2.28 percent, while property improvement loan delinquencies rose to 1.81 percent from 1.60 percent.

The number of delinquent bank card accounts also climbed 20 basis points to 4.38 percent, but still remain near the five-year average of 4.40 percent.

“The rise in consumer credit delinquencies is consistent with a rapidly slowing economy,” said James Chessen, ABA chief economist. “Stress in the housing market still dominates the story but it’s a broader tale of an overall weak economy.”

Chessen noted that delinquencies will likely continue to rise during the first half of the year and suggested that overextended borrowers get in contact with their lenders as soon as possible to negotiate financing options.

“No relief for consumers is in sight as food and gas prices remain stubbornly high and income growth is anemic,” Chessen concluded.

Recently, analysts have expressed concern that a lack of available home equity could cause borrowers to default on auto loans, credit cards, and other consumer loans.