The Federal Open Market Committee cut the Fed Funds Rate by 0.250 percent today.  The Fed Funds Rate is now 2.000% after the FOMC's seventh cut in eight months.

Normally, a cut in the Fed Funds Rate pushes mortgage rates higher.  So far, though, mortgage rates appear to be improving.  This is because the Fed's language hinted that the rate cuts may be over -- at least temporarily.

A "pause" puts focus on the Fool in the Shower theory.  It's something we've talked about before but if you don't feel like revisiting the concept in all of its glory, here's a summary:

The Federal Reserve's job is control the heat of the economy and one tool at its disposal is the Fed Funds Rate.  Lowering the Fed Funds Rate heats the economy towards inflation and raising the Fed Funds Rate cools it towards recession.

It's similar to taking the first shower in your home in each morning.  The water is usually freezing so you turn the knob all the way up to hot.  But then, the water gets too hot so you have to dial it back a bit.

The FOMC press release faintly signals that the Federal Reserve may start "dialing it back" a bit because of a stabilization in the economy and rising inflation.  Food and energy prices are very high, for example, and may threaten a business-led recovery.

In shower terms, the "economy water" is getting too hot.

Markets are interpreting the FOMC's press release to mean that future rate cuts are not a given, and that rate hikes could happen later this year.  That strengthens the U.S. dollar and reduces the impact of inflation -- two things that lead mortgage rates lower.

This is why mortgage rates are down thus far this afternoon.  Traders are changing their bets against the future of the U.S. economy and mortgage bonds are one of the beneficiaries.

The Fed's next scheduled meeting is June 28-29, 2008 -- that's a long two months from now.  If the shower water gets too hot or too cold in the meanwhile, it's likely that the FOMC's will meet in emergency to take action.

Source
Parsing The Fed Statement
The Wall Street Journal Online
March 18, 2008
http://online.wsj.com/internal/mdc/info-fedparse0804.html

This is a chart from RealtyTrac's Q1 2008 Foreclosure Report.  It is misleading.

A common conclusion that people make from charts like this is that foreclosures are the cause of falling home prices.  That's false.  There may be a relationship between the two, but one doesn't necessarily cause the other.

Home prices fall when the supply of homes outweighs the demand for homes.

Yes, foreclosures can increase the amount of homes for sale in an area, but the demand-side of the equation is equally important as a predictor of home values.

Supply and Demand is the basis of all pricing.

Now, some parts of the housing demand equation are constant from season to season -- families outgrow their homes and move-up to larger ones; or desire a specific neighborhood in which to raise childen; or downsize into retirement. 

Other parts of home demand, however, are elastic.

For example, when the economy is sluggish, the number of real estate investors tends to diminish, as does the number of people asked to move for job-related reasons.  This slows the influx of buyers to a region, city, or neighborhood and places downward pressure on home prices.

And falling Consumer Confidence impacts demand for homes, too. 

When Americans are dubious about their economic future, they tend to play it safe(r).  Unsettled about financial prospects, homeowners will often choose stay in their current home versus buying a new one. 

Nationwide, consumer confidence levels are their lowest levels since the early 1990s.

And lastly, demand for home is subject to elements of psychology.  Some people simply don't like buying into a market they perceive to be falling.  Coincidentally Ironically, that becomes a self-fulfilling prophecy and the market spirals lower.

Because of the perceived Cause-Effect relationship between foreclosures and home prices, people like to cite a foreclosure "statistic" that's really just an observation.  The common belief is that for every foreclosure in a neighborhood, nearby home values lose 1 percent of their value. 

This is untrue because there's no evidence that values fell because of the additional home supply.  It's more likely related to the demand for homes.  In other words, there may be a relationship between the defaulted mortgage loan and falling values, but it's definitely not a direct one.

Home values fall for the same reason that foreclosure levels rise -- there's not enough buyer demand to cause otherwise.

(Image courtesy: Antihero Comics)

Using mash-up software, the graphic depicts Countrywide Home Loan's "declining markets" against a map of the country.  The brighter the "spot", the more that housing values are expected to fall in that locale.

It's no wonder that home appraisals are under tremendous scrutiny lately -- many parts of the country are considered "at-risk".

The graphic is also another representation of the same theme we've been hashing out lately: Getting approved for a home loan is more difficult for even the most qualified mortgage applicant.

It's not just the person that has to be approved by a lender now.  It's the home, too.

Homes in declining markets are subject to all of the following:

• Adjustments to maximum loan-to-value limits
• Added fees from "field appraisals"
• Longer underwriting times

In addition, because Fannie Mae's risk-based fees are based on loan-to-value, closing costs can be higher in declining markets, too.

Now, in the interest of fairness, let's remember that lenders play both sides of the story; the current reaction to declining markets is the polar opposite of how lenders behaved during the booming housing market earlier this decade.

Some mortgage guidelines allowed 125% loans against a home's value then because property values were rapidly increasing.  Lenders didn't mind a little "excess lending" then and today they just happen to be on the other side of the spectrum.

We recently talked about how changing mortgage guidelines are impacting Americans and this image is a terrific complement.

In the last 24 hours, every business television program and newspaper has carried some variation of the "Home sales sink to 17-year low" headline. 

It's a negative-sounding headline and it ignores basic math and statistical analysis.

First, the New Home Sales report included a margin of error that was so large the Census Bureau had to add verbiage to its footnotes that read, paraphrased: "We don't know if New Home Sales increased or decreased last month.  This is our best guess."

Second, look at the graph above.  Of course New Home Sales fell last month -- just look at how sharply Housing Starts have fallen, too.  If fewer homes are being built, it makes sense that fewer homes are being sold. 

So, instead of citing 17-year lows, the better statistic for the press to report would have been the 11.0 month supply of new homes on the market.  Because it's up from 9.8 in February, buyers may now have additional negotiating leverage with developers that want (or need) to get their unsold, newly-built homes off the books pronto.

Just because the headlines read like bad news doesn't mean that the story is bad news, too.  Dig a little deeper for the real story, or if you don't feel like doing your own analysis, let me do it for you every business day and deliver it to you by email.