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Is the Federal Interest Rate Cut Enough to Stabilize Sub Prime Mortgage Woes?

Dec 16, 2007
As the sub prime mortgage debacle continues to play out across the United States, the Federal Reserve has opted to cut interest rates by half a percentage point, from 5.25. This cut makes all loans relatively cheaper, thereby encouraging a pantheon of economic activity to increase, hopefully in the troubled housing market.

Such tactics have been used with relative success in the past, most notably in 2000 when the US economy suffered a major downturn in the wake of the dot-com collapse. This collapse triggered a recession, which took three years to completely stabilize.

Since 2003, the Fed has slowly brought interest rates up in order to help keep dangerous inflation and reckless consumer spending down. These effects have been in line with forecasts at the time, showing that the Fed was relatively in touch with potential economic problems.

Yet the slow buildup of the interest rates may have occurred too late for them to be high enough to combat the problems in the housing market because the federal interest rate still has a limited and indirect effect on housing purchases, which depend on a myriad of other factors, not least of which is the agreed interest rate on a given mortgage.

Since those terms are decided between the lender (companies like Countrywide) and the borrower, (regular people) a rate cut can have many positive effects on overall spending without targeting the sickly housing market directly.

Even though the Federal Reserve have made a definitive statement on the seriousness of sub prime mortgage defaults by cutting rates for the first time in four years, they are convening imminently to discuss a further rate cut, of an estimated .25. This rate cut will certainly stimulate some aspects of the US economy, but its effects on mortgages are less predictable.

This is because unlike other, larger areas of the economy like job growth and retail spending, housing loans are tied to many other secondary industries that suffer slumps regularly whenever too many houses are on the market. Examples include the auto industry and the household appliance market, which accounts for many products that are still made in the US.

The increasing interest rates of the past several years have had a negligible effect on the ability of lenders to lure millions of Americans into signing up for a sub-prime mortgage, even when as many as one third of those who have these faulty contracts would have qualified for safer prime mortgages. Rising interest rates also did little to curb the booming housing market and its aforementioned secondary industries from expanding, possibly to proportions that cannot be sustained.

So will another interest rate cut be enough to bring back the mortally wounded housing market back from the brink of death? The possibility exists, but it appears to be unlikely without some other mechanism for assisting the housing market.

The Fed works like an opiate- it treats all symptoms by allowing a patient in a lot of pain to get much-needed rest, but does little do address an underlying specific cause. Most would agree that, despite the rise in interest rates over the past several years, the economy has been relatively robust. Yet the sub prime mortgage issue has gone unchecked for years, while millions of Americans who have bought into the classic dream of owning a home despair and the lender/broker machine goes on unchecked.

The only reason this fleecing of (usually) the poorest homeowners has come to any economist's attention is because of the spread of these faulty mortgages through markets all over the world. Without some degree of governmental regulation over lending practices, and reexamining the credit reporting agencies that allowed risky mortgages to be converted into bonds and securities in the first place, a federal interest rate cut can only do so much. Whether that is enough to stimulate the economy away from a recession is still unfortunately up in the air.
About the Author
Ki works for an Austin Realty company. He primarily works with clients interested in central Austin real estate . If you are interested in the Austin market a good starting off point is his website which offers a free search of the Austin MLS.
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