Federal Reserve & Interest Rates

Despite the improved outlook for financial markets and the record low mortgage rates, many analysts are skeptical that this will result in a recovery of the housing market any time soon.  Still, this may slow the bleeding in the housing market as mortgage holders try to take advantage of low rates to refinance, potentially keeping them from adding to the problem by avoiding foreclosure in the future.

Unfortunately most banks are still operating under tight lending standards, so the people who will benefit the most in the short run are those with impeccable credit scores.  The big problem is that secondary security markets have yet to recover from the initial sub prime collapse and quite possibly never will.

So while the Fed’s decision last week to purchase mortgage debt from Fannie Mae and Freddie Mac will initially increase the amount of mortgage originations in the short run, the two GSEs as well as other lenders will likely find it difficult to rollover this debt due to lack of private investment sources.  It will take time for investors to regain confidence in mortgage securities and in the meantime credit expansion will be slowed.

There is pretty much going to be a fundamental change in how financial markets work and that’s not even taking into account the many changes that will occur once the government finishes it’s regulatory overhaul of the financial system.  For all intents and purposes the originate to distribute model that banks had been operating under for so many years is dead and buried and many analysts doubt we will ever see the level of private investment that is required to make that system worthwhile once again.

The government has tried to take up the slack in the short run but most people feel that’s all it is, a short term solution.  Think of it this way, banks borrow short but lend long and in the past banks repackaged their loans and due the build up of secondary markets over time and the ease of resale, these securities in essence acted as short term assets for prospective investors.

The concern for many banks is what happens once the government turns off the spout.  Ideally they would like to borrow as much as they can in the short term and build up capital because with interest rates as low as they are right now, obviously the expectation is that rates will rise sometime in the future.

A lot will depend on the slope of the yield curve and how it changes over time once the government’s intervention ceases.  Basically it’s a waiting game on what will happen first, the return of private investment in the financial system or the government’s well running dry.