In an emergency move to prop up credit markets, the Federal Reserve cut the discount rate to 3.25 percent over the weekend and expanded the list of banks and financial institutions that can borrow money at that rate.

The Fed also announced Sunday that it was standing behind J.P. Morgan Chase’s move to buy troubled investment firm Bear Stearns Cos by providing up to $30 billion in financing that protects J.P. Morgan from losses.

The Federal Reserve Board’s Open Market Committee is expected to approve a large reduction in its target for the federal funds overnight rate, which is currently 3 percent, when it meets Tuesday. While investors had been betting the committee would cut the rate by 50 to 75 basis points, many now see an increased likelihood the rate will be cut by 100 basis points, to 2 percent.

Although the federal funds rate and the discount rate are short-term interest rates that do not directly influence rates on fixed-rate, long-term mortgages, some adjustable-rate mortgage (ARM) loans are tied to the discount rate.

ARM loans are more commonly tied to the London Interbank Offered Rate (LIBOR), another overnight rate that has also fallen as the Fed has slashed the federal funds rate five times since September, from 5.25 percent to 3 percent.

While short-term interest-rate reductions have helped reduce "payment shock" ARM borrowers experience when the introductory interest rates on their loans expire, the Fed’s actions have come at a cost.

Many economists blame cuts in the federal funds rate for a decline in the dollar’s value and rising energy and commodities prices. Those inflationary pressures could, in the long run, lead to higher long-term interest rates, and increasing the cost of taking out a mortgage and reducing the purchasing power of home buyers.

Fears about rising delinquencies and foreclosures in pools of mortgage loans that serve as collateral for mortgage-backed securities (MBS) have reduced the value of many such investments, with those still willing to buy them often demanding higher returns for the risk involved.

Banks and financial institutions that hold those and other debt securities have been forced to write down their value. Investment firms and lenders that borrowed money to take even larger, leveraged stakes in such securities have faced margin calls from creditors to cover their losses. A glut of such securities has flooded the market, pushing down their prices.

Bear Stearns, which has been forced to write down the value of its MBS investments by $2.75 billion, was unable to quell rumors that the company faced a liquidity crisis and lost the confidence of creditors and clients. J.P. Morgan Chase plans to buy the firm for just $236 million, or less than 3 percent of the company’s book value in the fourth quarter of 2007, MarketWatch reports.

J.P. Morgan is agreeing to guarantee all of Bear Stearns trading obligations, which could help keep its securities from flooding the marketplace.

Over the weekend, shareholders in Carlyle Capital voted to wind the highly leveraged private equity fund down after creditors seized more than $20 billion in MBS guaranteed by Fannie Mae and Freddie Mac when the fund couldn’t meet margin calls. The margin calls were prompted by the declining value of those securities, which served as collateral for the fund’s debt.

Alt-a "super jumbo" lender Thornburg Mortgage Inc. has also been hit by $1.8 billion in margin calls from creditors even though the loans the company has originated have performed well (see Inman News story).

The new lending program announced by the Fed Sunday is the latest attempt to help companies holding debt securities borrow against them instead of selling them at fire sale prices. The plan is to allow commercial banks and investments banks — so-called "primary dealers" — to borrow money overnight at the discount rate through the Federal Reserve Bank of New York, using collateral including mortgage- and asset-backed securities.

The new program, which will be in place for at least six months, supplants the current discount window lending program, which investment banks are not eligible to use. In lowering the discount rate, the Fed also extended the term of loans made at the discount window from 30 days to 60 days.

The primary dealers eligible to borrow from the New York Federal Reserve include J. P. Morgan Securities Inc., Goldman, Sachs & Co., Lehman Brothers Inc., Morgan Stanley & Co. Inc., Merrill Lynch Government Securities Inc., Citigroup Global Markets Inc., HSBC Securities Inc., and UBS Securities LLC (see list).

Last week the Federal Reserve announced it would lend $200 billion in Treasury securities to banks and investment firms, allowing them to pledge mortgage-backed securities as collateral, and the week before that said it would increase monthly auctions of 28-day loans from $60 billion a month to $100 billion a month (see story).


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