Fed Moves to Calm Investors Over Credit Crunch

Under the shadow of a growing liquidity crisis at some U.S. banks heavily invested in subprime mortgages, the Federal Reserve lowered its discount rate by half a percentage point early Friday to reassure financial markets it will act to stave off market meltdown.

Last week was a particularly brutal week for U.S. and global stocks as many lenders, led by mortgage giant Countrywide, showed signs of impending failure centered around heavy losses in the subprime sector. At particular issue was banks’ liquidity: their ability to pay debt obligations.

To stave off a potential mass sell off on Friday, the Fed in a surprise move reduced the rate it charges to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank’s lending facility. Rather than affecting broader interest rates paid by consumers, like the more well-known Federal Funds Rate, the discount rate applies only to banks. It stood at 6.25 percent before the Fed cut it to 5.75 percent. A cut in the rate generally means banks have easier access to cash to meet debt obligations.

But the cut could signal a change in Fed policy towards the Federal Funds Rate which sets interest rates for consumers. As a part of the announcement of the discount rate cut, the Fed also indicated that it may be willing to cut rates when it meets again in September.  The Federal Funds Rate currently stands at 5.25 percent.  The general consensus amongst analysts is that the Fed will cut interest rates in September to allow consumers easier access to credit.

The move on Friday was little more than one of reassurance to investors, according to most. “This move should be seen more as a reassurance step, should inter-bank liquidity begin to dry up again,” strategists at ING told MarketWatch.

The stock market responded to the surprise move Friday by surging more than 230 points.  Trading early Monday was mixed but generally slightly higher.  Around midday, however, stocks once again took a downward turn.

The move will probably have little impact on the ARM industry, according to one advisor.  Mark Russell of Kaulkin Ginsberg Company said that some larger merger and acquisition deals may be impacted by the overall credit crunch, but that “the Fed was moving to calm fears on Friday and it’s still too early to tell what the move will mean in the long-run.”