In the past when the Federal Reserve cut the discount rate it translated into lower mortgage interest rates for home buyers. This was a convenient way for the Federal Reserve to stimulate the economy during economic slowdowns. By making it easier for people to get loans more cash was pushed into the economy.

But the recent discount rate cuts have failed to have a similar effect. In fact the spread between mortgage interest rates and the discount rate is the greatest in 20 years. Although the Fed has cut rates 3 time in 2008, going from 4.25 to 2.25, if we look at a mortgage rates graph over the same time period we have failed to see much of a change. Two explanations have been put forth to explain why our current situation differs from what we have seen in the past. The first explanation is that the banks are facing almost 200 billion in losses from their misplaced bets on subprime mortgages, and are sticking with high interest rates to offset some of these losses. The other explanation is that banks still see a downside in the real estate market and are attempting to limit their exposure.

Considering that the mortgage industry is comprised of 1000's of people I doubt either of the views is completely accurate. Additionally, considered how short sighted the mortgage industry was in their foolish bets on subprime mortgages during the boom time I think partially the mortgage industry is simply reacting. During the boom time the mortgage industry reacted by competing with each other to create more and more bizarre loan products to allow people with poor credit to receive loans, in order to gain market share. Now that the real estate market is doing poorly the mortgage industry is spooked and is reacting by limiting access to loans.

Is there a light at the end of this tunnel? It's hard to tell. The latest Fed cut from 3 to 2.25 received a positive response from the market as interest rates fell from 6.13 to 5.87 the following week. But its anyone's guess of whether this is a temporary blip or a sign that the mortgage industry is comfortable with the current spread between mortgage interest rates and the Fed's discount rate. If the later is the case future rate cuts should have a more favorable affect on pushing down mortgage rates. While this won't cure the current woes in the real estate market it should help alleviate some of the problems.

One thing that does seem more likely is that if the real estate market continues to suffer the Fed will continue to cut rates. The current Fed Ben Bernanke chairman gave a speech before the subprime crisis detailing out how the Fed failed to respond strongly enough during the events which led to the great depression and seems determined to not make the same mistakes. In fact, in an unprecedented move the Fed injected over 200 billion in the credit markets last week its clear the Fed is committed to doing whatever it can to cure the credit/mortgage crisis. If the banks start reacting to the rate cuts the Fed might be able to succeed in their mission to take a stronger role in preventing an economic recession.