FED Bails Out Borrowers

With as many as 2 million sub-prime mortgages, scheduled to reset to much higher levels by the end of 2008 many market watchers began to get worried in the last few months, which drove the stock market down.

A sub-prime mortgage is a loan offered to borrowers with spotty credit histories and with interest rates rising, those resets could push the payment on a typical mortgage up $300 or $400 per month. This could push those borrowers into foreclosure.

The FED is worried that those foreclosures could snowball if liquidity is tight and send the country into recession. So this week FED chairman Ben Bernanke unveiled a two pronged attack. 

The first prong was a 1/4% reduction in the FED funds rate which should put some downward pressure on the interest rates these borrowers will have to pay once their rates reset.

The stock markets reaction to that move was almost non-existent.  Meaning those in the know figured this move wouldn’t help much. 

Less than 18 hours later Ben broke out the big guns and literally created $64 Billion out of thin air.  Interestingly, there is said to be $50 Billion in sub-prime resets in October alone.

The markets rejoiced and rallied sharply. Because that meant that the banks would have lots of money to lend and the party could go on a bit longer.

With more money the banks can extend credit at below market rates to the sub-prime borrowers and prevent the snowball ride to recession.

Unfortunately, that means that someone has to pay for it.  Bernanke says it won’t hurt anyone and everyone will benefit. But one of the basic laws of the universe is “there ain’t no free lunch”  and that applies to Ben too. 

So who will pay? 

You will pay, as the purchasing power of your dollars erode.  Remember the cause of price inflation (increasing prices) is monetary inflation (increasing the money supply). So by definition your dollar will buy less next year because of  Uncle Ben’s actions this week.

Will this help the sub-prime borrower?  Well increased liquidity in the markets should make getting a loan easier and when supply increases and demand stays the same, prices should go down. 

In other words, increased liquidity in the lending market should lower interest rates and make it easier to refinance.  This combined with the downward move in the FED funds rate should help sub-prime borrowers more than the President’s highly publicized sub-prime bailout.

The rate of resets will increase over the next few months and peak in March 2008 so at that point competition for loans will also peak.

For those whose loan is going to reset in 2008 this might be a good opportunity to lock in rates… while all this money is flowing and before all the competition sops up all the liquidity.