What to Do When the Fed Cuts Rates

We considered refinancing our building’s underlying mortgage last spring, but the board ultimately decided to wait because interest rates were rising. Since then, the Federal Reserve Bank has cut interest rates several times, so we thought that now might be a good time to do the deal. However, after contacting several of the banks that we had called last time, we found that underlying mortgage rates haven’t changed that much. When the Fed cuts rates, don’t all the banks have to cut theirs?

You’ve asked a simple question that, unfortunately, doesn’t have a simple “yes” or “no” answer. When the Federal Reserve Bank cuts interest rates, it can be adjusting the discount rate, or its target for the Federal Funds rate, or both. The discount rate is a fixed interest rate that the Fed charges its member banks for short-term loans. The Federal Funds rate is an interest rate, determined by supply and demand in the marketplace, that banks charge each other for overnight loans.

Whenever the Fed adjusts either of these key rates, the effects appear almost simultaneously in other short-term interest rates. For example, most money center banks will change their “prime” lending rate, usually by the same increment as the Fed changes. The rates on U.S. Treasury securities with maturities of two years or less typically trade in the same direction as the Fed’s adjustment. Many consumers will notice a similar change in the interest rate on their credit card statements as well as a parallel adjustment in the interest rate paid on their savings and money-market accounts. So, the “yes” part of my answer is that most banks and other financial institutions do raise or lower their interest rates whenever the Federal Reserve makes a change.

However, Federal Reserve policy is just one of the many factors that influence mortgage and other longer-term interest rates. First, most mortgage lenders set the interest rate on a new loan by adding a margin, or “spread,” to some market index. Lenders use a variety of indexes, depending on the type of loan that they are making. Many commercial mortgage lenders, including most co-op underlying mortgage lenders, use the rate on 10-year U.S. treasury securities. These are favored as safe investments by many institutional investors, and their rates fluctuate daily in response to supply and demand in a broad, active market. The 10-year treasury rate is reported in the financial pages of most major newspapers and on many financial websites like cnnmoney.com or bloomberg.com.

The rate on 10-year treasuries does not move in lock-step with changes that the Fed might make in short-term interest rates. As fixed-income investments, treasuries often are used as alternatives to equity investments like stocks. And, because the rate on a fixed-income instrument varies inversely with its price, a “good” day for stocks often means a “bad” day for treasuries (i.e., lower prices and higher rates).

In addition, since treasury securities are backed by the full faith and credit of the U. S. government, they are viewed worldwide as relatively risk-free “safe haven” investments in times of political and/or economic upheaval. For example, an increase in Mideast tensions could generate a surge in treasury investments. That increase in demand will drive up treasury prices and reduce their rates…totally independent of any Fed action.

Alternatively, let’s assume that the Fed cuts short-term interest rates by a relatively aggressive half-point to prop up our sagging economy. If the broader market views that change as doing more to ignite inflation than to spur economic activity, treasury rates actually might trade higher! So, the market’s perceptions of Fed actions sometimes have a greater effect than the actions themselves.

A second determinant of mortgage rates is the spread that a lender adds to the chosen index when pricing a loan. Many co-op board members are surprised to learn that spreads also trade daily, just like the 10-year treasury rate. Loan spreads are “built up” by adding together two principal components. The first component is the so-called “Wall Street spread,” or the return demanded by secondary market investors who buy loans from lenders after closing. Even if lenders don’t plan to sell their loans, they still underwrite virtually all of them to the standards required by the secondary market. The Wall Street spread reflects general money market conditions as well as investor perceptions of – or uncertainty regarding – future market conditions. Whenever there is turmoil in the financial markets, this component of the loan spread is where it shows up. To put this in perspective, as the wider effects of the subprime mortgage mess became more apparent, the Wall Street spread grew by more than 100 basis points!

The other piece of the loan spread is the “lender spread,” or the fee charged by the lenders for servicing the new loan during its term (i.e., collecting the monthly payments and handling all of the administrative issues related to the loan) plus their profit. A lender may choose to decrease either or both of these amounts for competitive reasons, or they might decide to increase either or both of them because of uncertain market conditions or profit goals.

After many years of relative calm and growing prosperity, world financial markets are now in disarray because of the subprime mortgage debacle. What initially was thought to be a problem confined to a small segment of the U.S. single-family home mortgage market has grown to a worldwide financial crisis affecting virtually every financial transaction in some way. The effect within the co-op underlying mortgage market has been a dramatic increase in loan spreads, averaging almost 10 basis points per month over the last year.

Fortunately, the 10-year treasury rate has fallen by almost the same amount over that period, so the net effect on underlying mortgage rates has been minimal. However, since the decline in treasury rates has received lots of coverage in the press, while the rise in spreads has not, the general public feels that lenders must be doing something “fishy.”

For the most part, lenders are a pretty honest and hard-working lot. The people who smell are the unqualified borrowers who lied on their loan applications, the lenders who looked the other way while closing subprime loans to unqualified borrowers, the rating agencies who didn’t do their homework, and the greedy investment bankers who misrepresented all of that junk while selling it to institutional investors. The good news is that underlying mortgage rates are pretty good, despite this mess. So, go do your deal!