Here are some facts:
1. If the Fed were to cut rates to help ARM debt service, what happens when the next resets come about in the next month, 3 months, 6 months or next year (depending on the mortgage contract)? Suppose significant defaults do occur; and they will because this is not a subprime issue, it is an issue of lax underwriting standards since banks were giving away money that was not theirs. Since they weren't underwriting off of their balance sheet capacity but instead underwrote with the anticipation of selling the risk off, bad loans and defaults weren't their problem after the first year risk retention period had expired, hence the popularity of 2/28 ARMS. I digress... Assume the Fed cut rates, those who are going to default aren't going to default because interest rates are high (they are actually damn close to historical lows). They are going to default because they were given a loan they couldn't afford due to lax, "it's not my money" underwriting, secured by collateral that was bought at the top of a raging bull market that is now declining in value. So if this does occur, does the FED drop rates every time a reset period occurs? What happens when we get to zero or negative real rates??? Japan redux??? What happens to the dollar? This all goes without saying that dropping rates in response to financial market foibles is what got us here in the first place.
2. 3 month USD LIBOR has recently risen to 5.72% while the two year treasury is under 4%, primarily due to the fact that the banks (the actual financial insiders) do not trust each other enough to lend past over night without a significant premium while the treasury does not carry a risk premium. This alone should tell the smart money that there is real risk floating around, not just paranoia. Bulls, caveat emptor! USD LIBOR is what many ARMS are pegged to, plus a risk premium spread determined through underwriting (see point 1 for reference on underwriting with someone else's monies!). This LIBOR/Treasury spread is the highest in 6 years (since 9/11 attacks) and at least double the average spread over Fed Funds rate.
3. The Fed Funds rate is at 5.25%, and the US stock and futures market has already priced in a 25 - 50 basis point rate cut, despite the fact that the Fed has made it clear that the credit issue has not significantly seeped into the wider economy according to beige book stats.
4. The Case/Schiller home value index shows a -3.2% drop in single family home values nationwide, the biggest drop since it was calculated, back to 1987. If you read my previous analysis, this index excludes a LOT of the property that is relevant to the pricing declines and defaults that are occurring. So if it says we're down 3.2%, I'll put my money on being down at least 4%. This is just for the month, with a 2 month lag built in. Real time across all residential real estate classes, look towards being down closer to 5%. Remember, this is the collateral that secures these underpriced mortgages with “too slim” risk premiums that are set to increase in debt service to many marginal borrowers who stretched just to get the teaser rate covered. The reset rates are governing about $50 billion dollars of debt service per quarter. That is a decent amount of “extra interest”.
5. So, suppose the Fed cuts rates 25 or even 50 basis points… The banks still do not trust each other. They all know that they, as well as their peers, used the “Hey, it ain’t my money so I’ll push the loan through!” underwriting methodology, then repackaged the loans into the junk bond cum AAA securitized debt alchemy, and sold it off to whoever would buy it, worldwide, but got caught with some of it on their own books, funds and SIVs. This would still lead to a spread of LIBOR over Fed Funds rate. Then what does the Fed do? Listen; if there is arsenic in your spring water bottles in the supermarket, no matter how low you discount the price of that water, no one is going to want to buy it. The reason is the price wasn’t the problem in the first place, it was the arsenic. Well, poorly underwritten loans on devaluing property is like arsenic, fellas (and gals).