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Fifty Basis Points and Counting?

The Federal Reserve Board's decision to cut its key short-term interest rate by 50 basis points was meant, clearly, as a lifeline to the troubled mortgage industry. With defaults skyrocketing, especially on subprime credit quality loans, with billions of dollars worth of adjustable-rate mortgage products approaching resets that would sometimes onerously raise monthly payments, the Fed is trying to stave off disaster. The question is will the Fed's vigorous efforts to bolster liquidity for the mortgage industry and the credit markets generally backfire? And is the Fed done cutting rates?

At this point, there's good reason to have confidence in Fed chairman Ben Bernanke's captaining of the ship. When he raised rates early in his term to keep inflation within acceptable limits, some thought he might have gone too far. But with price growth appearing controlled and with housing values falling nationally - sharply in some markets - he was willing to change course and use the Fed's power to minimize the risk that a weak housing sector could plunge the economy into recession. So far so good, especially for homeowners who are trying to refinance out of problematic loan products before their payments get too high.

But the Fed rate cut comes with plenty of risk for mortgage servicers, because the same actions designed to limit payment increases and keep housing finance affordable could spark another refinancing binge. And while most applauded the Fed's decision to cut interest rates by 50 basis points, the move was not without its detractors.

As The Wall Street Journal pointed out, only a month before the rate cut the Fed said it was more worried about higher inflation than weaker economic growth. Allan Meltzer, a professor at Carnegie Mellon University, was quoted in the Journal saying that the rate cut was a mistake, similar to cuts in the 1960s and 1970s that allowed inflation to ratchet up.

But sometime between August and September, the Fed's view toward housing grew more worrisome. In a recent speech, Fed vice chairman Donald Kohn said that while the Fed's basic view of the economy hasn't changed much since early August, the housing sector has continued to weaken. He said that shortly after the August Federal Open Market Committee meeting, "financial market conditions deteriorated considerably further," leading to disruptions to nonprime mortgage markets that began even to affect higher credit quality home loans. This, it appears, was a key factor behind the Fed's decision to cut rates.

So far, long-term mortgage rates have edged down only modestly in response to the Fed rate cut. They are not low enough to spark a new wave of rate-induced refinancing. But the risk remains that if the economy becomes sluggish, rates could fall further, sparking higher-than-anticipated refinancing and impairing the value of mortgage servicing rights.

In the Fed's own minutes from its Sept. 18 meeting, it's clear that housing market conditions remain a key focus guiding the Fed's policy decisions. While the Fed gave no indication as to whether it may or may not cut interest rates further, my best guess is that the Fed will take a wait and see attitude, at least through the end of this year. The 50 basis point cut was more than many had expected, but there's nothing in the Sept. 18 minutes that suggests the Fed thinks additional cuts are needed at the moment. In addition, statements from Federal Reserve Board members who do not currently serve on the FOMC that votes on changes to the fed funds rate suggest that while the September vote to cut rates by 50 basis points was unanimous, there are dissenting voices within the Fed's senior ranks who may think that was too much at one time. The Fed plays its hand close to the vest, but lingering concern about inflation may diminish hope for an additional rate cut in the near future. (c) 2007 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com/ http://www.sourcemedia.com/