Fed offers $200-billion shot in arm
Attempting to break the credit logjam that is threatening the already weakened economy, the Federal Reserve on Tuesday announced a new program to pump massive sums into the financial system.
The battered stock market, which on Monday had fallen to its lowest levels in at least 18 months, responded with its biggest one-day rally in five years. The Dow Jones industrial average rocketed 416.66 points, or 3.6%, to 12,156.81.
In a surprise, the Fed said it would begin to temporarily lend major banks and brokerages as much as $200 billion in U.S. Treasury securities it owns, in exchange for mortgage-backed securities that in many cases have slumped in value because of market anxiety over soaring loan defaults.
With rock-solid Treasury bonds in hand, Fed officials hope, financial firms will return to something closer to normal investing and lending practices. That could ease the credit crunch that took hold with the housing market’s plunge last summer but since has spread to many unrelated corners of the banking system and economy.
“They’ve pulled out all the stops to try and fix this problem,” said Christopher Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi in New York.
Behind the huge dollar amounts involved in the Fed’s latest move, experts said, is an urgent need to restore confidence in the financial system before the mood of investors and consumers gets so bad that policymakers can’t turn it around.
“There is a danger of a downward spiral in the economy,” Rupkey said. “They have to address it.”
Many economists believe that the country has already entered a recession. The government Friday reported a net loss in February of 63,000 jobs, the most in five years.
When Fed policymakers meet next Tuesday, they are expected to again reduce their benchmark short-term interest rate from the current 3% to at least 2.5%.
Despite five cuts in its key rate since August, however -- and previous announcements of smaller programs to pump money into the financial system -- the Fed has been unable to reverse a cycle of tightening credit, falling home prices and tumbling securities markets.
Senior Fed staff members who spoke to reporters Tuesday on condition that they not be further identified said the central bank was frustrated with the lack of progress in bolstering the financial system.
“They’re on Plan B now,” said James Glassman, senior economist at JPMorgan Chase & Co. in New York. “The Fed knows there’s a lot of danger here.”
The new Fed program was approved in a conference call of central bank officials Monday evening, after a less ambitious lending plan was announced Friday.
Earlier Monday, Wall Street had been rocked by rumors that Bear Stearns Cos., one of the country’s largest brokerages, was running short on cash because other financial giants wouldn’t lend to it. The company’s shares plunged 11% even though the firm said there was “absolutely no truth” to the rumors.
Also Monday, shares of Fannie Mae and Freddie Mac -- the two government-sponsored lending giants that are supposed to help lead a housing-market rescue -- dived to their lowest levels since 1995 after a weekend story in Barron’s, a financial magazine, questioned whether Fannie Mae itself could become insolvent.
When the mortgage-finance crisis began last summer, it was centered in the so-called sub-prime loan market for mortgages made to people with dicey credit. As delinquency rates on those loans surged, the value of bonds backed by the mortgages crumbled, causing massive losses for banks, brokerages and investment firms that owned the bonds.
In recent months, Wall Street’s fears of greater losses on home-loan-backed bonds have intensified as the outlook for housing and the economy has worsened. Even many bonds backed by the highest-quality mortgages have gone begging for buyers.
That has made major banks more reluctant to lend to each other as well as to brokerages and investment funds saddled with large portfolios of mortgage-backed securities, and has further depressed financial markets.
What’s more, the turmoil helped push mortgage rates up sharply in February, after a decline that had pulled the average 30-year loan rate below 6% in January to the lowest since 2004.
In effect, the Fed has found itself pouring liquidity into a financial plumbing system with a frozen pump.
Now, by agreeing to exchange Treasury bonds for mortgage bonds in temporary swaps with financial institutions -- including brokerages such as Bear Stearns -- the central bank is hoping to halt or even reverse the decline in the value of high-quality mortgage securities, analysts said.
“The Fed is trying to say, ‘This isn’t as bad as some of you think and we’re going to put our money where our mouth is,’ ” said Brian Bethune, an economist at Global Insight, an economic forecasting firm in Lexington, Mass.
If policymakers can persuade cash-hoarding investors that they shouldn’t wait any longer to snap up mortgage bonds, the result could be an explosion of buying that could feed on itself, analysts said.
Opportunistic investors “never wait for the problem to be solved -- they just wait for the lessening of the problem” before moving in, said Joseph Carson, an economist at investment firm AllianceBernstein in New York.
Under the Fed’s plan, the Treasury-bond loans will be for 28-day periods instead of overnight, the traditional period for such swaps. The program will begin March 27 and will include the cooperation of central banks in Europe and Canada.
Fed staff members stressed that the central bank would take only top-rated mortgage securities as collateral, not risky sub-prime bonds. Approved bonds include those of Fannie Mae and Freddie Mac.
“It’s a very creative approach,” said Diane Swonk, chief economist at Mesirow Financial in Chicago. “It will go pretty far in addressing the confidence issue” regarding bonds backed by the highest-quality mortgages.
Fed officials indicated that the program could expand beyond $200 billion. The Fed has $713 billion in Treasuries in its portfolio.
Still, some experts said the Fed’s temporary securities-swap program wouldn’t solve the main problems weighing on the financial system -- which are that many lenders and investment firms are saddled with bonds backed by deeply troubled home loans, and that defaults continue to rise as home prices sink.
Scott Simon, a mortgage-securities expert at Pacific Investment Management Co. in Newport Beach, a leader in bond mutual funds, said he believed that the Fed ultimately would have to begin buying mortgage-backed bonds outright and hold them in its portfolio to take the burden from the financial system.
The Fed and the Bush administration have opposed such a move, saying the government shouldn’t bail out the mortgage market.
But Simon said the problem had become too big to fix without direct federal intervention.
In normal times, “I think the government isn’t supposed to get involved in any of this stuff,” Simon said. “But if this goes unabated we will have a depression, not a recession.”
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maura.reynolds@latimes.com
