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


Richard Moore


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 

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 

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

Eric Dash contributed reporting from New York.

Copyright 2008 The New York Times Company

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