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Fed Cuts Interest Rate to Stem Panic
Wall Street Rebounds After Shaky Opening; Foreign Markets Up

By Neil Irwin and David Cho
Washington Post Staff Writers
Wednesday, January 23, 2008

The Federal Reserve slashed a key interest rate by three-quarters of a percentage point yesterday, a bold action designed to prevent steep losses in world stock markets from causing an all-out panic.

The rate cut, the largest in 24 years, soothed financial markets. The Dow Jones industrial average fell 1.1 percent, far less than the drops of 7 percent and more that staggered Asian and European markets earlier in the week. After the cut was announced, stock prices moderated in Europe and Asia.

Investors in futures markets are betting there is a strong likelihood that the Fed will cut rates again at its regularly scheduled meeting next week.

The cut in the federal funds rate, to 3.5 percent, should make it cheaper for consumers to borrow money with credit cards or through home-equity loans, or for businesses to take on loans to expand. It should also lead to lower rates on most adjustable-rate mortgages, though it is less likely to affect rates for long-term, fixed-rate home loans.

The cut did not immediately restore confidence to key segments of the debt markets, which are at the root of the problems threatening the economy with recession. There is also increasing concern in the markets that the tax cuts and other stimuli being discussed by President Bush and Congress will not ease the underlying credit crunch.

"The financial system has been infected," said Mark Zandi, chief economist of Moody's Economy.com. "Providing tax cuts and lower rates gives policymakers more time to solve the problem, but it doesn't heal the infection."

Yesterday's rate cut was dramatic for its scale; after the Sept. 11, 2001, terrorist attacks, the Fed cut rates by only half a point.

Fed leaders decided not to wait until next week's meeting to act. Although they worried that they might be seen as overreacting to stock-market volatility, they figured there was even greater danger if they did not move. Left unchecked, a hard-to-reverse cycle could set in with giant worldwide losses leading to a severe recession in the U.S. economy.

The central bank cut the rate "in view of a weakening of the economic outlook and increasing downside risks to growth," the Fed's policymaking committee said in a written statement. Credit is becoming harder to obtain, the housing contraction is worsening, and so is the labor market, the statement said. It said that Fed leaders expect inflation to moderate in the coming quarters, and that they "will act in a timely manner as needed to address" financial and other risks, both signals that the central bank is inclined to continue cutting rates.

The latest rate cut was on top of a full percentage-point reduction that the central bank enacted over its previous three meetings.

In the view of Fed leaders, the U.S. economy is slowing so that a large interest rate cut was justified by conventional economic analysis. But it was the crisis in financial markets and mounting gloom that created a reason to enact the cut between meetings, a practice that Chairman Ben S. Bernanke resists.

In the view of Fed leaders, a decline in the stock market is not, in and of itself, a reason to cut interest rates. In this case, the policymakers viewed the declining stock prices around the world not so much as an inherent problem but as emblematic of declining confidence in the financial system.

Lower rates, in addition to making it less expensive for consumers and businesses to borrow, stimulate the economy in other ways. They cause weakness in the price of the dollar, which helps U.S. exporters. And they make banks more profitable, which in the current crisis could allow them to rebuild their capital positions and get on more solid footing.

The rate cuts, coupled with proposed tax cuts and spending increases, could shore up confidence among companies and consumers. But they do not directly address the root cause of the crisis -- a set of bad bets made by financial players all over the world over many years that roiled the fundamental business of lending money.

Those who trade in complicated debt securities based on mortgages or other kinds of loans said those markets generally remained troubled despite the rate cut.

"Everyone is still pretty spooked right now. People are still in a wait-and-see mode," said Kerry Kantin, who covers the trading of buyout loans for Standard & Poor's Leveraged Commentary & Data.

Policymakers have struggled to contain the credit crunch because so many financial firms tied their fortunes to the housing industry by buying mortgages, packaging them and trading them like securities. That business started to spread the risk of making the loans across many parties and, for years, it generated huge profits and fees for Wall Street's biggest banks. Financial firms, hedge funds and investors around the world rushed to get a piece of the action.

Now, as defaults and foreclosures soar to record levels in the United States, these mortgage securities are plummeting in value, and even the most savvy investors aren't sure what they are worth. Firms around the world, facing huge losses, can't sell the securities, and their ability to support all kinds of loans is threatened. The cash spigot is closing.

"Financial engineers for the past five years created a whole bunch of defective products that are nothing but blind pools of bonds and loans that are of very poor credit quality, but through the magic of financial alchemy were sold as good credits," said Ed Yardeni of Yardeni Research.

This "credit recession," as some Wall Street analysts have termed it, is in some ways more dangerous than other downturns the nation has faced because it threatens both consumer and business spending.

Fed officials are particularly concerned about the financial health of bond insurers, some of which may be close to failing. Those firms help municipalities and companies with weak credit borrow money, but over the past few years they also delved into the business of providing insurance for mortgage-backed securities.

The insurers now have to cover more losses than they can afford. If any of them fail, the value of the municipal and corporate bonds they insure would suffer a huge drop.

Nearly 5,000 bonds insured by Ambac Financial Group were downgraded yesterday and have dropped in value. On Friday, Fitch Ratings downgraded Ambac itself.

The rating of another bond insurer, ACA Capital Holdings, was cut from investment grade to near junk by Standard and Poor's last month after the company revealed that it faces $60 billion of mortgage-security insurance losses that it can't pay. Yesterday it won a month's grace to unwind these contracts from the people who bought the insurance.

New York insurance regulators, officials of the Federal Reserve Bank of New York, and many of the biggest firms on Wall Street are discussing how to infuse new capital into the bond-insurance companies to prevent the losses from rippling through the financial system.

The New York State Insurance Department has persuaded billionaire investor Warren E. Buffett's company, Berkshire Hathaway, to enter the market for municipal bond insurance. (Buffett is a director of The Washington Post Co.)

"What's going on is the unwinding of probably the biggest credit bubble in history," said David Shulman, senior economist at the UCLA Anderson Forecast. "It will take a while to undo this, and it could get very messy."

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