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A Tale of Two Unknowns: The Fed's Second 2007 Emergency Meeting

Stocks in this article: BAC

The argument split into two directions: What if virtually none of the banks approach the discount window, despite a drop in the rate? Or, what if the "8,000 banks and many more depository institutions than that" all clamor at once to the window?

The latter situation raised some concern.

" A nother issue of the narrower spread over the federal funds rate is that, as Brian Madigan pointed out, you probably increase the number of people, and so there are also some operational issues relating to the staff that the Federal Reserve Banks are managing," said New York Fed President William Dudley, who was then the manager of the System Open Market Account. " T here is an issue in terms of the operational burden and our capacity to do that, given that this is basically very rarely used in the current environment."

Simply, Dudley raised the concern that if the 50-basis-point reduction in the discount rate triggered an avalanche of loan requests, the Reserve banks across the country may not have enough humans to deliver the funds.

The issue never arose, but the conversation offers a view of the uncharted landscape the Fed was about to wander through.

The other argument unfolded about a lack of bank participation.

The stigma to approach the discount window was that banks felt if they asked for loans from the Fed, then market participants would view those banks as weak. Stronger banks, the reasoning suggested, wouldn't want to do business with weaker banks, which would thusly exacerbate problems.

The Fed also didn't want to send the impression to markets that conditions in the financial services sector were spiraling (again, at that time, the Fed didn't observe the rising problems as a crisis of historic proportions).

What to do?

Fed Chairman Ben Bernanke and others recommended a 50-basis-point reduction, while others argued for a 75-basis-point decrease.

Those in favor of 75 basis points feared that 50 basis points wouldn't maximize the effect of bringing banks in need of liquidity to the discount window.

The argument about the difference of 25 basis points gripped the FOMC's conversation and weaved itself throughout the meeting. Ultimately, Geithner made the decisive argument for the 50-basis-point cut: If it didn't work, the Fed would know larger problems were brewing.

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