Does PGH Bank have enough reserves to meet the deposit withdrawals and still meet the reserve requirement? How much should it borrow from the Federal Reserve Bank as the Lender of Last Resort?

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3. In January 2006, PGH Bank sold half of its mortgage loans to an investment bank at a 10% discount, and a month later uses the proceeds to buy AAA mortgage-backed securities with 8% yield from the same investment bank. During the first 9 months of the year, its checkable deposits increased by $80 million and commercial loans granted increased $100 million.

Beginning June of that year, terrible news hits the mortgage markets: defaults on subprime mortgages increased due to rising interest rates. A lot of foreclosed homes flooded the market and home prices were falling significantly. Even though the remaining mortgage loans on PGH Bank’s balance sheet were made to prime borrowers, the decline in home values caused its market value to drop 30%. By September 30, 2006, the market for mortgage-backed securities has frozen and PGH Bank could not find a buyer for its holdings. In addition, news of a local bank being closed down by the FDIC led to withdrawals of $30 million by panicky depositors. The federal funds market froze. PGH Bank wanted to sell some of its commercial loans to come up with more reserves, but other banks were also short of reserves due to the bank panic.

a) Does PGH Bank have enough reserves to meet the deposit withdrawals and still meet the reserve requirement? How much should it borrow from the Federal Reserve Bank as the Lender of Last Resort?

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b) With mark-to-market accounting, what will PGH Bank’s balance sheet look like at the end of the third quarter 2006 after the discount loan from the Federal Reserve Bank?

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c) Assume that to be adequately capitalized a bank has to have at least 6% in capital to risk-weighted assets. Is PGH Bank adequately capitalized? If not, how much capital infusion does it need from the government to become adequately capitalized?

 

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