FEDERAL RESERVE DISCOUNT RATE CUT COMMENT
by David Urban
August 17, 2007

This morning, in a surprise move, the Federal Reserve cut its discount rate by 50 basis points from 6.25% to 5.75% in order to provide additional liquidity and restore normal operations to the discount window. The discount window is used to provide short-term liquidity to financial institutions and provide a source of funds for lending in the federal fund window.

During the recent panic, the Federal Reserve has been injecting the banking system with short-term flows of capital in order to keep the system liquid and functioning properly. The Federal Reserve will take collateral in return but it is the collateral and margin requirements which have been causing the most problems.

The Federal Reserve Board (FRB) noted in the first sentence that this rate cut was temporary so expect an increase or non-cut balancing out a cut in the Fed Funds rate when liquidity improves.

The more interesting points come later in the statement when the FRB notes that they have extended the borrowing term to 30 days, renewable by the borrower. This signals to me that there may be a couple of banks with problems in the system. If so, this provides additional liquidity and gives the banks more time to sort through their problems.

The Federal Reserve can and has been accepting home mortgages and what may appear to be mortgage backed bonds and CDO�s (they use the term similar instruments) as collateral for borrowing at the discount window. That is no surprise as they have been doing this for years and is a part of their guidelines. But, they are not changing their existing collateral margins. So as the value of the mortgages and securities used as collateral drops the banks are required to place additional securities to make up for the deficit. This is where we had the liquidity drain the past week. As levered hedge funds watch the prices for their mortgage backed bonds and CDO�s drop, they received margin calls and this spilled over into the banking arena.

For clues as to where the problems are located and what banks may be involved, just look to the final sentence. The request for a reduction in the discount rate was submitted by the Federal Reserve Banks of San Francisco and New York. Because the Federal Reserve Bank of New York hold so much clout over the committee it would not be surprising if San Francisco initiated the request after receiving backing from New York.

What happens next? From past experience, if a bank is in trouble the Federal Reserve will bail it out the bank by arraigning for a friendly merger with a larger bank. The larger bank will get some favorable terms with the FDIC on the lending side in order to assist in the assimilation of the loan book as well as a favorable purchase price.

© 2007 David Urban
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David Urban
Kingston, PA USA
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