The Federal Reserve is facing a difficult but necessary transition from activist investor to pulling back its involvement and allowing higher short-term rates when the economy can stand on its own.

Last week the Federal Reserve took a small step toward reducing its involvement by raising the discount rate by .25% (The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank’s lending facility). The Fed did recently indicate that the move might be coming, yet the timing of their announcement was surprising to many.

At the start of the credit crunch in mid 2007, nearly one-third of the U.S. lending mechanism was frozen. To increase their liquidity, banks had the option to access the Discount Window at the Federal Reserve (Federal Reserve Banks offer three discount window programs to depository institutions: primary credit, secondary credit, and seasonal credit, each with its own interest rate. All discount window loans are fully secured.) However, because costs for these funds were high AND repayment had to be done within 28 days, most lenders were unable to utilize this option. As a result, the Fed held an emergency meeting, lowered the Discount Rate and extended the repayment period to 90 days. These changes made the Discount Window option a viable solution for lenders and helped curtail the severity of the mortgage meltdown. Last week’s announcement reverses those emergency measures.

When making this change, the Fed noted that the continual improvement in financial market conditions gave them the foundation for this move. The Fed also said that they do not anticipate this raise to lead to tighter financial conditions for households or businesses nor does this move indicate any change in their outlook for the economy or for monetary policy.

However, as the Fed makes changes, the government backs out of Mortgage Backed Securities (MBS) purchases and slows down stimulus programs, we continue to assess economic growth and inflation concerns.

With that in mind, one of the most popular measures of inflation within the U.S. is the Consumer Price Index (CPI). The CPI measures the estimated average price of consumer goods and services purchased by households. This index rose by 0.2% for January, less than the 0.3% expected. With the publishing of the January results, the year-over-year CPI is at 2.6%, below expectations of 2.8%. The more closely watched Core CPI (which strips out food and energy costs), actually fell by 0.1%, below expectations of a 0.1% rise. The last time Core CPI showed a negative monthly reading was 28 years ago. This helped to drop the year-over-year Core CPI rate to 1.6%, a bit below expectations of a 1.8% rise.

These results show that, for the time being, inflation is a non issue. However, it will likely become a factor in the next year or two. And, the best hedge for inflation is to fix as many costs at today’s prices as you can. A home purchase today with a historically low mortgage rate allows buyers to fix the price of their home and the associated financing costs. We will continue to keep an eye on this index and other economic indicators.

Excerpts from an article on CMN Money.com, on February 2010:

As terrible as it is to lose your house to foreclosure, at least it’s a relief to put your biggest financial headache behind you, right?

Wrong.

Former homeowners may still be on the hook if there’s a difference between what they owed on their mortgage and what the bank could sell it for at auction. And these “deficiency judgments” are ticking time bombs that can explode years after borrowers lose their homes.

It can even happen to people who got their bank to approve them selling their home for less than it is worth.

Vanessa Corey, for example, short sold her Fredericksburg, Va., home in April 2008. She and her husband built the house in 2004, but setbacks, both personal (divorce) and professional (housing bust), made it impossible for the real estate agent to keep her home. So she negotiated the short sale and thought that was the end of it.

“My understanding was that the deficiency was negotiated away,” she said. “Then, last November, I got a letter from a lawyer telling me I owed my lender $65,000. I had to declare bankruptcy. There was no way I could pay it.”

Many homeowners are now in the same boat. And not just those who took out bigger loans than they could afford or who did so called “liar loans” where they didn’t have to verify their income.

Because of falling home prices, borrowers who always paid their mortgage but who have run into unforeseen circumstances — like unemployment or a job transfer — can no longer sell their homes for what they owe. As a result, they are being forced to short sell or foreclose and are getting caught up in deficiency judgments.

“After the banks foreclose, it’s very common now to have large deficiencies with houses not worth the balances owed,” said Don Lampe, a North Carolina real estate attorney.

Whether banks can and will pursue deficiency judgments depends on many factors, including what state the borrower lives in and whether there’s a second mortgage or other liens. But if borrowers ignore the possibility of deficiencies, it could haunt them.

“Once they have a judgment, they can pursue you anywhere,” said Richard Zaretsky, a board-certified real estate attorney in West Palm Beach, Fla. “They can ask for financial records, have your wages garnished and, if you fail to respond, a judge can put you in jail.”

In the case of foreclosure, lenders can pursue deficiencies in more than 30 states, including Florida, New York and Texas, according to the U.S. Foreclosure Network, an organization of mortgage law firms.

Some states, such as California, are “non-recourse” and don’t allow deficiency judgments. But, even there, if the if the original loan was refinanced, some or all of it may be subject to claims.

Deficiency judgments on short sales and deeds-in-lieu can happen in many more places. In these cases, extinguishing the debt is often a matter of negotiating with the bank.

But even when lenders are willing, many borrowers may not be aware that they have to ask for release. So, if you are pursuing a short sale, be sure to ask the bank to release you from any further obligation.

Ticking time bomb

What can be scary is that the judgments don’t have to be obtained immediately. Lenders or collection agencies may wait until debtors have recovered financially before they swoop in. In Florida, the bank can wait up to five years to file. Once the court grants a judgment, the lender has 20 years there to collect, with interest.

It doesn’t have to be a large amount of debt for a lender or collection agency to come after borrowers. Richard Varno and his wife short sold their Nashville home back in 2004 after he lost his job.

It wasn’t until 2008, when the second lien holder asked him for $25,000, that he realized he still was liable.

“I told them, ‘Hey, you guys released the title,’” he said. “As far as I know, I’m off the hook.”

He wasn’t. Releasing title does not necessarily end the debt. It’s complicated because of variations in state law, but, generally, a mortgage has two parts: a pledge of collateral, represented by the home, and a promise to pay off the loan.

Lenders may release property liens in order to facilitate short sales without releasing borrowers from their obligations to pay under the promissory notes. The secured debt can convert to an unsecured one after the sale.

Lenders are also very inconsistent. One of Zaretsky’s short-sale clients was ready, willing and able to pay, but the bank did not even ask; another lender always reserves the right to pursue the deficiency.

Strategic defaults

Sometimes lenders go after borrowers walking away from their homes if they have other assets, according to Florida real estate attorney Larry Tolchinsky.

“Banks are pulling credit reports to see if it’s a strategic default,” he said. “If you’re behind on all your other payments, you’re okay. But if you’re not, they’ll come after you.”

If borrowers have any doubts about their risks, they should seek legal advice. Or, at least, call non-profit organizations such as NeighborWorks for advice. According to Doug Robinson, a NeighborWorks spokesman, its counselors always try to negotiate away deficiencies when they facilitate short sales or deeds-in-lieu.

“We don’t favor any short-sale contracts that leave any deficiency that can be pursued,” he said.