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Answer:
Dear Mr. Kirtz,
Your
question is a surprisingly timely one. The discount
rate is usually in the background, rarely mentioned
in the news unless the rate changes. Recently, however,
it has moved to the front page.
Definition
The
discount rate is the interest charged by the Federal
Reserve on loans it makes to its member banks.
The Fed uses government securities or eligible paper
as collateral for these loans. (Eligible paper
consists of banker's acceptances, commercial paper,
and other negotiable instruments.)
Member
banks of the Federal Reserve System include all
nationally and state-chartered banks that apply for
membership -- and are accepted.
Once
accepted, member banks are required to maintain a
percentage of their own cash deposits on reserve in
the form of currency at their Federal Reserve district
bank. This reserve rate varies depending on
the size of the bank as well as the type of deposits
it has. Generally speaking, larger banks have a higher
reserve rate than smaller banks.
Back
to the discount rate...
The
discount rate provides a floor on interest rates nationwide,
since banks set their own loan rates to customers
at a notch above the discount rate.
The
Federal Reserve can also control the flow of money
by changing the discount rate. When the discount rate
is low and therefore borrowing is less expensive for
member banks, this ultimately results in lower interest
rates on loans for bank clients, thus encouraging
borrowing in the form of mortgages, home equity loans,
car loans, personal, educational and business loans
and credit card advances.
When
borrowing is easier and cheaper, people and businesses
spend more and the economy expands.
A
low discount rate also means lower interest rates
on bank CDs, money market funds and bonds and, at
the same time, greater interest on the part of investors
in stocks.
Last
Friday
Last
Friday, August 17, 2007, in what many thought was
a surprise move, the Federal Reserve cut the discount
rate from 6.25% to 5.75%. At the same time, it extended
discount loans (traditionally overnight) to up to
30 days, renewable at the borrower's option.
This
is seen as a move on the Fed's part to curb the subprime
mortgage crisis, in particular with those lending
companies offering loans to borrowers with poor credit
histories.
The
next thing that happened was that four of the nation's
major banks (Bank of America, Citibank, JP Morgan
Chase and Wachovia) each borrowed $500 million from
the Fed's discount window.
The
"window" is where member banks can borrow money on
a short-term basis, usually overnight, from the Fed.
It offers a way for the Fed to buffer shocks to the
money markets. For many years, it was difficult to
borrow from the window and in fact, it was seen as
a stigma to have to do so. Then, in 2003 the Fed made
it easier by no longer requiring banks to prove they
could not borrow elsewhere. And they no longer had
to explain why they needed a loan. These changes were
made to encourage healthy institutions to borrow from
the window. And that's exactly what just happened.
Back
to the current scenario...
On
Wednesday of this week, August 22, 2007, Bank of America
made a $2 million investment in one of the nation's
largest mortgage lenders. (This mortgage lender has
been heavily involved in the sub-prime mortgage business,
which we discussed in a previous column. Click HERE
to read.)
Foreclosures
and defaults among borrowers with poor credit or who
have lost their jobs have been plaguing the subprime
mortgage business.
The
Market's Reaction
After
the Fed lowered the discount rate, and the announcement
was made regarding the four banks taking out loans
from the discount window, the market rose -- both
the Standard & Poor's 500 Index and the Dow recovered
from previous lows. It seemed that the sub-prime mortgage
situation was being addressed, although not necessarily
totally resolved.
I
hope this answers your question on the role of the
discount rate. If you need additional information,
don't hesitate to write us again.
Good
luck!
BUYandHOLD
does not recommend any securities. The securities
mentioned above is being used for illustrative and
informational purposes only and should not be regarded
as an offer to sell or as a solicitation of an offer
to buy.
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