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Central Banks Launch
Effort to Free Up Credit
In Bid to Revive Lending;
Europe, Japan Weigh In
December 13, 2007
In the biggest coordinated show of international financial force since Sept. 11, 2001, the Federal Reserve yesterday joined four other central banks in a plan aimed at coaxing banks to lend more readily at a time when fear has seized up world credit markets.
Just a day after it cut its key rate for the third time this year, the Fed said it will extend up to $40 billion in loans in the next eight days to banks. To ease banks' concerns about their own ability to borrow, the Fed said it would lend at a lower rate than it typically charges on such loans while accepting a broad range of collateral.
The European Central Bank and the British, Swiss and Canadian central banks simultaneously announced new or expanded operations to prime their nations' banks with additional cash. The Japanese and Swedes chimed in with rhetorical support. The Fed also agreed to provide U.S. dollars to the ECB and the Swiss central bank that can be supplied to their dollar-hungry lenders. The Fed last took such a step in the days after al Qaeda's 2001 terrorist strike on America.
Yesterday's action is aimed at addressing an increasingly worrying dilemma for the Fed. The central bank has cut interest rates three times since August by a total of a full percentage point, with the most recent quarter-point cut coming just on Tuesday. But bankers and investors nevertheless have become increasingly jittery, and reluctant to lend to business, consumers and even to each other. Meanwhile, signs continue to spread that the American housing-market meltdown, the related turmoil in money markets and high energy prices are pressing on the U.S. economy. The Fed fears that reluctance to lend could push an already stalled economy into recession.
The Fed has tried to solve twin problems since the financial crisis hit in August. One has been to cut rates enough to cushion the economy from a collapsing housing bubble, but not so much that it ignites inflation. The other has been to overcome the credit crunch that has muffled the economic benefits of those rate cuts.
So far, the medicine isn't working. The rates banks offer to consumers and each other have stayed stubbornly high. The Fed tried to encourage financial institutions to use its discount window to increase their liquidity, but there were few takers. Separately, the Bush administration has prodded big banks to create a new entity to buy some mortgage-linked securities that don't have a ready market now, and more recently has pressed a plan that calls for mortgage-servicers to freeze interest payments on perhaps hundreds of thousands of qualifying homeowners whose mortgage payments are set to rise.
Markets initially received the news positively: the Dow Jones Industrial Average leaped 270 points. But the joy quickly receded, and the blue chips ended the day at 13,473.90, up just 41.13 points. It retraced only a fraction of the losses sustained Tuesday on disappointment that the Fed didn't cut interest rates more or show more appreciation of the gravity of the credit crunch.
A key gauge of the strains in financial markets, the rate banks charge each other for three-month loans in U.S. dollars, did respond, however, dropping more than a quarter-point to a low during the day of 4.88% from 5.06% before the Fed move. The rate, known as the London interbank offered rate, or Libor, is widely used as a benchmark both for the cost of banks' own funds and to determine the rates of many adjustable-rate loans, so it is important to many homeowners facing potentially higher payments as their mortgages reset. In a symptom of stress in money markets, the rate has continued to rise even as the Fed brings its main interest rate target, the federal funds rate, down. and the gap between Libor and the fed funds rate remains unusually wide.
Many analysts were more sanguine than the market about the Fed's latest move, but emphasized the increasingly big challenge the Fed still has in making market rates respond effectively to its moves.
"The Fed is feeling its way in the dark here; current conditions are unprecedented in modern times," said Ian Shepherdson of High Frequency Economics. "We think these measures are a step in the right direction, but there is simply no way to know for sure how effective they will be."
The Fed's restraint in lowering its target rate partly reflects a painful reality: The steps the Fed has taken since August haven't made substantial difference in thawing credit markets. It is now clear that a lack of cheap funding is only one reason banks and investors are so reluctant to lend. Financial institutions remain suspicious of each other after multiple rounds of announcements of mortgage-linked losses, and are anticipating more. They also are eager to hold onto cash to shore up their troubled balance sheets.
Indeed, yesterday Bank of America warned current-quarter results will be "quite disappointing" amid further write-downs on complex debt securities, depressed trading revenue and deepening credit losses.
"The fundamental issue is the world suspects there are a large volume of defaults on mortgage collateral, you don't know who has them, you don't know how much, so there's withdrawal," said Vincent Reinhart, a former top Fed staffer now at the American Enterprise Institute think tank. He noted that total reported write-downs of impaired mortgages to date are still a fraction of the lowest estimates of total losses.
Tom Gallagher, an analyst at ISI Group, a brokerage firm, said financial markets believe the solution isn't targeted efforts to thaw lending conditions, but "more aggressive cuts in the federal funds target rate."
The Fed is reluctant because it fears sparking inflationary pressure that would be difficult to alleviate. Indeed, yesterday's action helped send crude oil futures up, something that is likely to keep those inflation fears alive.
Fed officials acknowledge that the latest plan isn't a cure-all, but believe it will help by giving banks a secure source of funding that is cheaper and carries less stigma than the Fed's discount-window loans, traditionally the place where banks go in desperation.
The Fed will accept an array of assets as collateral, from subprime mortgages to credit card receivables. The European Central Bank and the British, Swiss and Canadian central banks simultaneously announced new or expanded operations to supply their banks with additional cash, and the Japanese and Swedes chimed in with rhetorical support. The Fed also agreed to provide U.S. dollars for the ECB and Swiss central banks to lend to their dollar-hungry banks, as it did with several central banks after Sept. 11, 2001. At the same time, the move gives the Fed more flexibility to add cash to the economy than through the traditional tool of open market operations. Together, this might help the struggling U.S. economy in ways that simply lowering interest rates cannot.
Some bankers agree. "More than lowering rates in the economy, just having this banking system liquefied will make a huge difference," Ken Thompson, chief executive of Wachovia Corp., the nation's fifth largest bank, said at a conference yesterday following the Fed's 9 a.m. announcement. The reason rates for loans among banks are so high, he said, is that banks and investors "are still fearful of each other and everybody is worried about counterparty risk and so people are hoarding their balance sheets, and this will help that."
With Tuesday's quarter-point cut, the Fed now has lowered its main interest rate target, the federal funds rate at which banks lend to each other overnight, by a full percentage point. But other short-term rates have not moved down in tandem, as they normally do, reducing the potency of the Fed's medicine.
The most prominent sign of that is that the Libor, a benchmark for many dollar-loans between banks especially in Europe, has shot up as much as 0.8 percentage points above the federal funds rate. The gap is normally less than 0.2 points. A high Libor rate raises banks' costs of funds and thus the rates they charge borrowers. In addition, many U.S. homeowners have adjustable rate mortgages with linked to Libor.
The new Fed strategy resembles tools used by other central banks, notably the ECB and the Reserve Bank of Australia, and the Fed said it will consider adding the tool to its arsenal more regularly. "There's a little bit of ECB envy here," Mr. Reinhart said. Fed officials believe one reason Australia's Libor rate has experienced one of the smallest increases may be its central bank's ability to lend to a wide variety of institutions and accept a wide variety of collateral.
The seeds of yesterday's plan were planted in the late 1990s when Fed staff were making contingency plans for how they to conduct monetary policy if the federal government paid down all its Treasury bond debt or if the year-2000 Y2K computer bug interrupted the supply of cash to the banking system. Staff at the time proposed auctioning off discount window loans from the Fed. Mr. Reinhart, who worked on the plans, said the need never arose. The plan was never implemented.
The Fed revisited the idea, along with numerous others, in late August as Fed officials realized that lowering the discount rate and easing its terms hadn't had the desired impact. At first, they set the plan aside as financial markets steadily improved and Libor dropped. In November, as strains re-emerged, the plan was again dusted off.
While the plan is primarily the Fed's, it invited international support early. The crisis from the start has been global: Some of the banks that have taken the biggest hits are based in Europe, and because they generally can't borrow in dollars from their own central banks, they have turned to Libor, pushing it up.
Specifics were hammered out by telephone at the top levels of the five central banks involved. Yesterday's announcement date was settled on last week, in part so the Fed's policy committee, the Federal Open Market Committee, could sign off on certain aspects at a previously scheduled meeting. Fed officials said they did not announce it Tuesday afternoon along with their rate decision because European markets and central banks were closed then.
The plan was designed to address two specific shortcomings with how the Fed currently pushes cash into the financial system. Its main tool now is "open market operations," under which it lends for between one and 14 days to a network of 22 bond dealers, accepting as collateral only Treasury debt or securities issued by or guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae. In the current environment, bond dealers are reluctant to give up such safe securities and have pleaded with the Fed to accept more out-of-favor securities, such as mortgage-backed securities backed by jumbo mortgages not guaranteed by Fannie or Freddie. The Fed believes it cannot do so by law. The ECB by contrast can accept a wide range of collateral.
At the discount window, the Fed can accept almost any kind of collateral, including subprime mortgage-backed securities, as long as the value of the collateral exceeds the loan by enough to protect the Fed from loss. But banks aren't tapping the discount window.,
Under the new method, the Fed will hold four auctions of discount window credit. The first two, for $20 billion each, will be held next Monday and Thursday for four- and five-week terms, respectively; two more, for undetermined amounts, will be on Jan. 14 and 28. The auctions are structured so that the rate on the loans will be no lower than the market's expectations for the fed funds rate, and probably no higher than the discount rate.
"There is no reason to believe there would be stigma associated with the use of this facility," a Fed official told a media briefing. Individual borrowing banks will not be identified. The Fed will report each week the total borrowed by banks in each of its 12 regions.
The other central banks announced parallel moves to boost cash to their banking system. The agreement with the Fed will enable the ECB and Swiss central bank to provide up to $24 billion in U.S. for their banks. The Bank of England said it would increase the amount of previously planned three-month funds to be auctioned and widen the range of collateral it accepts. The Bank of Canada said it would lend up to $3 billion over the year-end for which it will temporarily accept a broader range of collateral.
ECB vice president Lucas Papademos told reporters yesterday his bank agreed to the swap with the Fed because "some financial institutions headquartered in the euro area also have needs for dollar liquidity." The ECB ordinarily lends only in euros, but it was a demand for dollars -- sparked by the need to finance portfolios linked to U.S. mortgages -- that helped spark the current crisis on August 9. European banks were unable to borrow dollars that they needed, so they borrowed heavily in euros to convert them to dollars, pushing up euro-zone money market rates up and prompting aggressive actions by the ECB to push them down again.
"I don't think [the ECB] has the expectation or even the hope of normalizing the money market by just doing this," says Jose Alzola, European economist with Citigroup in London. "I think their aim is much more humble. It's just to facilitate funding around the turn of the year and avoid an escalation of the problem."
Still, three-month euro-denominated lending rates fell by some 0.2 percentage points -- from seven-year highs around 5% -- just after the announcement, a development Mr. Papademos called "positive."
In the U.S., economists and market watchers said the Fed's plan would ease, but not solve the economy's problems. "Will these facilities help? Sure they'll help," said Brian Gendreau, investment strategist at ING Investment Management. "Will they be enough to do the job? We don't know that yet."
Jeff Bronchick, chief investment officer at Los Angeles money-management firm Reed Conner Birdwell, said, "The big, big picture is that a bunch of people basically accepted much more debt than their balance sheets could afford. That has to be cured and it can only be cured with time."
--Justin Lahart and David Enrich contributed to this article.
Write to Greg Ip at greg.ip@wsj.com and Joellen Perry at joellen.perry@wsj.com
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