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

NEW YORK ( TheStreet) -- The Federal Reserve seriously was concerned it didn't have enough staffing to service the discount window in 2007.

Transcripts from the Federal Open Market Committee -- the Fed's policy-making wing -- from the early days of the financial crisis suggest that Fed members sometimes found themselves unfamiliar with the financial instruments that were beginning to cave and frightened by the prospects of encouraging more banks to approach its discount window to remain liquid.

During a second emergency meeting on Aug. 16, 2007, FOMC members debated the impending statement it would release the next day that said the central bank would reduce the primary credit rate -- one of three discount window programs it offers -- by 50 basis points to 5.75% in an effort to encourage banks to request loans from the regional Reserve banks.

Six days prior to this meeting, the FOMC had held its first emergency conference call of the approaching financial crisis to inform members that the central bank would be issuing a statement later in the day to say that it would provide liquidity to maintain "orderly functioning" of the financial markets. Troubles with Washington Mutual and Countrywide (now part of Bank of America ( BAC)) had tormented markets and the commercial paper markets in Europe and the U.S. started to face pressures.

But banks rapidly became more illiquid than the Fed had anticipated in the first meeting, and members opposed a bailout option. Members avoided bailouts as an option because it wasn't clear in August 2007 just how unhealthy conditions would later become. General worry among Fed bankers, according to the transcript, was that illiquidity was spreading and banks were afraid to approach the discount window.

The discount window -- where banks go to ask the Reserve banks for loans -- carried a negative stigma.

" I f somehow the stigma were reduced for coming to the window, they might be able to take advantage of that source of liquidity and act so that the help might relax some of the constraints in other markets," Timothy Geithner, then-president of the New York Fed and vice chairman of the FOMC, said in the emergency meeting.

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.

"If this does not have a desired effect, it will not be because we didn't do another 25. It will be because we're at the point where we're going to have to think about the fed funds rate," said Geithner, who then levied some dramatic irony. "So I don't think it is right ... to think that we will do it by just decision we will revisit that spread. We will have to think about more dramatic actions in that context."

On Aug. 17, 2007, the Fed issued this statement, which said it would cut the discount rate by 50 basis points and the target federal funds rate by the same amount.

"We are doing a very unconventional thing," Bernanke said at the end of the meeting.

-- Written by Joe Deaux in New York.

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