By Neil Irwin
Washington Post Staff Writer
Thursday, December 13, 2007
The Federal Reserve launched a concerted effort with central banks around the world to try to get financial institutions to lend money more readily, its latest attempt to help thaw a frozen financial system.
The surprise move, announced yesterday, less than a day after the Fed cut a key short-term interest rate, is an attempt by the central bank to prevent worsening problems in global credit markets from causing a U.S. recession. In this case, the tools are special auctions that would make at least $40 billion available to U.S. banks by the end of the year, and an agreement with the European Central Bank and the Swiss National Bank that would make $24 billion available to banks in Europe.
"The Fed has not only opened its vault doors to the banking industry, they are now trucking it to their place of business," Scott Anderson, a Wells Fargo senior economist, said in a report. "If that doesn't get the banks excited about lending again, nothing will, and the battle to forestall recession is already lost."
The effort underscores the global nature of the still-unfolding financial crisis. The coordinated action with the European Central Bank and national banks of Britain, Canada and Switzerland is the most extensive cooperation between world monetary authorities since the days after the Sept. 11, 2001, terrorist attacks.
Markets initially soared after the announcement yesterday. Investors were relieved by the news, having been disappointed Tuesday when the Fed did not announce any measures to improve global liquidity. The Dow Jones industrial average, up more than 200 points in morning trading yesterday, closed up 41 points, or 0.31 percent. Money poured out of short-term Treasury bonds, suggesting less fear on the part of investors.
As the Fed made its announcement, however, major banks made disclosures that underscore why they have been so reluctant to part with cash lately. Bank of America, Wachovia and PNC Financial Services each said they expect losses from bad debts to rise next year.
The "term auction facility," as the Fed calls its vehicle for making cash available, is a new creation, an idea the bank has been working on in recent weeks to deal with a complex and rapidly changing set of interrelated crises.
"This is a day-to-day learn-on-the-job kind of thing," said John Silvia, chief economist of Wachovia.
The sharp downturn in the U.S. housing market has led to massive losses on subprime loan portfolios, many of which are held by banks in Europe. That has undermined confidence in a wide range of debt products. Banks here and abroad are so worried that they may face further losses that they have been jealously guarding cash, refusing to lend money to one another except at interest rates much higher than usual. That elevation in interest rates has increased borrowing costs to many businesses and consumers, threatening to weaken the economy further.
In the past six weeks, the premium that banks have charged one another for overnight loans, relative to ultra-safe government bond yields, has risen sharply. The increase in the premium indicates that banks do not have faith in the extent to which they and their competitors are exposed to mortgage and other losses.
The plan announced yesterday is meant to stop that vicious cycle in its tracks. Fed leaders hope that rather than hoard cash, banks will borrow money through the special auction, thus easing fears of a cash crunch. They could borrow money through the "discount window" operated by the Fed, but such borrowing is widely perceived to be a measure of desperation.
The term auction, through which $20 billion will be available Monday and another $20 billion on Dec. 20, is designed to help banks get through a crunch of demand for cash through the end of the year. Because banks must bid on the money, with the institution offering the highest interest rate getting the cash, creators of the plan hope it will not suffer the same problems as the discount window.
"There is no reason to believe there would be a stigma associated with the use of this facility," a senior Fed official said in a conference call with reporters. The news briefing was a rarity for the generally secretive central bank, and all comments were made on the condition of anonymity.
If the auction works, analysts said, then the interest rate that banks charge one another, known as the London interbank offered rate or Libor, will drop relative to safer investments. Many business and consumer loan rates in the United States are based on the Libor, so that would effectively lower interest rates for many Americans.
Further auctions are planned for Jan. 14 and 28, though the amount of cash available has not been determined. The Fed suggested in a statement that if the auctions go well, they may become a permanent part of the set of tools it uses to ensure the financial system has sufficient cash.
There was some grumbling on Wall Street that the Fed did not announce the liquidity actions Tuesday afternoon when it announced its rate cut. Stocks plummeted after that announcement.
The Fed official said the announcement had been delayed so it could be coordinated with the other central banks'; European markets were closed when the Fed made its Tuesday announcement.
"I am surprised they couldn't get at least one sentence in the release that said 'we are working on a liquidity providing program and expect to make an announcement soon,' " Wachovia's Silvia said.