New York Fed Reportedly Prods Banks

News has surfaced indicating that the New York Fed encouraged The Clearing House to organize a telephone conference earlier today to discuss the Federal Reserve's discount rate cut and to encourage banks to borrow from the discount window.

This is good news in the sense that the Fed wants to show that its discount rate cut was more than symbolic. By encouraging banks to use the window and saying that such use would be "a sign of strength," the Fed reduces the stigma that for decades has been attached to discount-window borrowings.

Banks that borrow from the Fed are perceived to be in a weak position because in doing so it suggests that they were unable to obtain money from other banks and had to resort to the Fed instead.

The news that the New York Fed encouraged borrowing from the discount window could increase such borrowing, and it raises the prospect of a second cut in the discount rate that makes it equal to the 5.25% fed funds rate. The current rate, 5.75%, is probably too high for most banks to consider borrowing from the Fed, since banks are currently able to obtain money at 5.25% in the federal funds market.

If the Fed were to lower the discount rate to 5.25%, then there would be an economic reason to borrow from the Fed, and the stigma would be reduced. Banks that borrowed from the Fed at 5.25% could then say that they went to the Fed not because they were in trouble, but because the market was in trouble, with short-term funding difficult to obtain because of dysfunctional fed funds and commercial paper markets. Keep in mind that unlike the Fed's repo operations, the Fed accepts a wide variety of assets as collateral. For example, the Fed accepts corporate bonds, consumer loans, commercial real estate loans and residential real estate loans, among other securities.

This means that there is greater opportunity to liquefy instruments that are not easily converted into cash under current conditions in the capital markets, largely because collateral rejected by investors would be deemed acceptable by the Fed when granting discount-window loans.

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Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of the revised investment classic, The Money Market, first published in 1978 by Marcia Stigum, and The Strategic Bond Investor. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of Bondtalk.com, a popular Web site covering the bond market and the economy. Crescenzi appreciates your feedback; click here to send him an email.

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