Fed's answer: you & I bail out the banks

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Richard Moore

Mar 13, 2008, 6:07:59 AM3/13/08
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March 12, 2008

Fed Hopes to Ease Strain on Economic Activity

WASHINGTON ‹ Impelled to take extraordinary measures for the second time in less than a week, the Federal Reserve moved on Tuesday to subdue the deepening crisis in credit markets by stepping up as lender of last resort.

In an action that sent stock prices soaring, the central bank offered to let the biggest investment banks on Wall Street borrow up to $200 billion in Treasury securities in exchange for hard-to-sell mortgage-backed securities as collateral. And the Fed made clear that it was prepared to do more as needed.

The move, which was coordinated with central banks in Europe and Canada, came on the heels of two similar actions on Friday, in which the Fed offered up to $200 billion in 28-day cash loans to banks and big financial institutions.

But where investors were unimpressed by last week¹s efforts, which took place as the government announced that the number of jobs was falling, they were jubilant on Tuesday. The Dow Jones industrial average soared 416 points, or 3.6 percent, in its biggest increase in points in more than five years. The dollar enjoyed at least a momentary reprieve from its protracted plunge against other major currencies.

The Federal Reserve, in effect, is trying to ease an acute credit squeeze by agreeing to hold large volumes of mortgage-backed bonds that Wall Street firms are struggling to sell and providing them with either cash or Treasury securities that they can immediately convert to cash.

Fed officials are increasingly convinced that the United States is sliding into a recession, and they worry that the deepening credit squeeze will aggravate the problem by making it even harder for consumers and businesses to borrow money for houses, new equipment or new factories.

The Fed¹s hope is to relieve some of the pressure on institutions to sell at fire-sale prices, easing the strains on economic activity and making the credit markets feel more comfortable in buying mortgage bonds again.

Despite the staggering sums being offered by the Fed over the past week, some analysts warned that the new infusion of money might not be enough to fill the hole caused by the losses on ill-conceived mortgages during the housing bubble.

³They are essentially creating a $300 billion bank out of nothing,² said Lou Crandall, chief economist at Wrightson ICAP, a financial research firm.

But while the Fed¹s moves may relieve short-term cash problems, Mr. Crandall said, ³it doesn¹t solve the fundamental issue, which is the decline of capital in the banking system.²

Indeed, some analysts warned that the central bank might make things worse in the long run by postponing the repricing of mortgage assets that financial institutions are holding, or by further weakening the value of the dollar and aggravating inflation.

³The Fed is saying if you don¹t want those mortgages, then give them to us,² said Peter D. Schiff, president of Euro Pacific Capital, an investment firm in Darien, Conn. ³The Fed thinks that inflation is the way to solve our problems, but all this does is create bigger problems.²

Senior Fed officials said on Tuesday that the other concerns pale compared with the need to stabilize credit markets ‹ particularly markets for mortgages ‹ that have become increasingly trapped in a self-perpetuating downward spiral.

That spiral, which began last summer when defaults on subprime mortgages began to soar, has led to falling prices for almost all kinds of debt securities. The falling prices have forced selling by major institutional investors and lenders, partly to make up for other losses, and has spread to a much broader array of seemingly safe securities.

In its move on Tuesday, the central bank said that it would lend up to $200 billion in Treasury securities to a select list of top investment banks, known as primary dealers, that regularly trade with the Federal Reserve in its open-market operations.

The new twist is that the investment banks will be allowed to pledge as collateral a wide variety of securities that include hard-to-sell, privately issued mortgage-backed securities.

Fed officials, in a conference call with reporters on Tuesday, said that they were minimizing risk by accepting only securities that still had the highest triple-A ratings and that they would impose a ³haircut,² or discount, on mortgage bonds that appear to carry additional risk.

Even so, the Fed is accepting securities that are inherently riskier than its usual mix of Treasury securities and government-issued bonds.

To bolster its effort, Fed officials enlisted support from foreign central banks, including the European Central Bank, which said that it would lend up to $15 billion this month and would continue the program if needed. The Bank of England, the Bank of Canada and the Swiss National Bank will also participate.

Despite the global show of force, the reaction of bond investors was more subdued than what was seen in the stock market. Though the risk premiums, or spreads, on high-quality mortgage-backed securities edged down slightly, they were still much higher than normal.

Rarely, if ever, has the Federal Reserve scrambled to make so much money available in so many different ways in such a short time. On top of offering low-cost loans to banks and Wall Street firms, the central bank has reduced its short-term interest rate five times since last September, to 3 percent from 5.25 percent. Policy makers are expected to cut the benchmark rate at least another half-point when they meet on March 18.

One practical implication of the new lending program is that it may make the central bank more likely to lower the federal funds rate by half a percentage point rather than three-quarters of a point next Tuesday. Before the Fed¹s action, futures prices showed that investors were overwhelmingly betting on the deeper rate cut. But afterward, the odds declined to about 50-50.

In effect, the new program offers investment banks the same kind of access to comparatively cheap one-month loans the Fed has been offering to banks and savings institutions through its Term Auction Facility.

The main point of the effort on Tuesday was to prevent or at least slow a chain reaction of forced selling on Wall Street. In recent days, market prices for seemingly safe debt had fallen so much that major financial institutions were being forced to put up more capital to secure their debt.

Two big institutions ‹ a unit of the Carlyle Group, a large private equity firm, and Thornburg Mortgage ‹ rattled investors and Fed officials last week by failing to satisfy margin calls, or demands for extra collateral, by creditors.

Fed officials have been especially alarmed that the cascade of forced selling and falling prices has begun to infect mortgages guaranteed by Fannie Mae and Freddie Mac, the government-sponsored mortgage finance companies.

James K. Paterson, head of global funding for JPMorgan Chase, said the Fed¹s willingness to make short-term loans could relieve some of the strain.

³The banks only have so much room and it is difficult for them to provide all the liquidity that the market wanted, given their balance sheet constraints,² Mr. Paterson said. ³If you can stabilize the markets for a while, it is very constructive.²

But other experts were skeptical. The total volume of mortgage-backed securities is about $6.1 trillion, with almost $2 trillion in riskier nonagency securities that are not insured by the federal government or by Fannie Mae or Freddie Mac.

³We still believe today¹s action is not nearly a large enough step to make a big difference,² wrote David Rosenberg, chief United States economist at Merrill Lynch. ³As with all the Fed¹s steps to date, this move injects a bit more liquidity into the system, but does not cure the overall credit crunch or credit problems.²

Eric Dash contributed reporting from New York.

Copyright 2008 The New York Times Company

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