ARMs due to reset next year may fare better than those reset in 2007

It seems the subprime problem begins and ends with interest rates. Remarks by Fed vice chairman Donald L. Kohn that the fed will follow "flexible and pragmatic policy making" indicate that another rate cut may be in the works, reports The New York Times.

Read the article here.

As the Bernanke Fed ponders its third rate cut this year, another 25 basis points will bring the Fed funds rate to 4.25% at the December meeting. It appears the stock markets are ardently pricing in the cut, which, if it eventuates, will be good news for borrowers whose loan rates are due to reset next year.

If the rate cuts continue, subprime borrowers with adjustable rate mortgages (ARMs) due to reset next year may find themselves in a more favorable rate environment. Though cuts in the fed funds rate are not a straight pass through to the market lending rate, could this be a sign of stability the market desperately needs?

Subprime ARMs enticed borrowers with below prime introductory teaser rates that reset after a few years. Borrowers with low credit scores, poor credit histories or other circumstances preventing them from qualifying for a fixed rate prime loan found the ARMs option attractive.

Over the past twelve months, ARMs began to reset to market or above market rates, bringing with them a flood of defaults and delinquencies. In contrast to the low interested rate environment they were originated in, the loans were resetting amid Fed rate hikes and tightening credit market conditions.

Now, with market speculation of another cut, it seems future ARMs will reset more favorably, perhaps avoiding the increased default rates incurred this year.