Stocks Surge as Fed Offers A Boost

By Tomoeh Murakami Tse and Neil Irwin
Washington Post Staff Writers
Wednesday, March 12, 2008

NEW YORK, March 11 -- The Federal Reserve took bold action Tuesday to revive the economy's ossified credit markets by offering to take over the risk of spurned mortgage securities, igniting a rally on Wall Street that sent stocks to their best performance in five years.

Setting aside earlier reservations, the Fed essentially made itself the lender of last resort to investment banks squeezed for cash by offering them up to $200 billion in new credit against their holdings of highly rated mortgage securities that no one else is eager to buy. This move, coordinated with four other central banks, was the most aggressive step the Fed has taken to address the spreading credit crisis.

The Dow Jones industrial average of 30 blue-chip stocks responded to the morning announcement by jumping 250 points within the first moments of trading and ended the day up 416.66 points, or 3.5 percent, to 12,156.81. The Standard & Poor's 500-stock index, a broader market measure, rose 47.28, or 3.7 percent, to 1320.65. The tech-heavy Nasdaq composite index advanced 86.42, or 4 percent, to 2255.76.

But while the Dow's percentage gain was its steepest since 2003, the rebound in trading still left markets below where they'd been just a week ago. Nor did the move by the central bank address the underlying weakness of the economy triggered by widespread exposure to failing subprime mortgage loans, though the initiative did blunt the immediate threat: a run from even the safest high-grade bonds.

Until Tuesday, the central bank had been unable to reverse the downward slide of the U.S. economy despite a series of interest rate cuts and other steps to introduce liquidity into the system. The series of cuts to the federal funds rate had threatened to stoke inflation and, by driving down the value of the dollar, contributed to price rises in oil and other imported commodities. But these moves had done little to restore the confidence of banks, which have increasingly tightened the credit they offer to businesses and home buyers, even those with excellent credit.

All this was choking off already anemic economic activity. The government reported last week that the economy shed jobs for the second consecutive month. Consumer spending has softened, corporate profits have flagged, and both residential and commercial real estate have displayed new signs of stress.

In the past week, the vicious cycle accelerated. Bankers demanded that hedge funds and other investors holding troubled securities put up more cash to back them, prompting a sell-off of high-grade securities such as those issued by the mortgage giants Fannie Mae and Freddie Mac, to raise the money. Some investment funds, like one run by Carlyle Group of the District, could not meet these margin calls, and they defaulted. Rumors of trouble at one of the largest Wall Street banks, Bear Stearns, and speculation that other banks would soon disclose new, staggering losses, added to the mounting panic.

So the Fed moved Tuesday to auction up to $200 billion in Treasury securities, which will be available to large financial institutions if they put up collateral including highly rated mortgage-backed securities. The aim was to make Wall Street firms more confident about buying and holding these mortgage investments and provide an outlet for them. This could free up money for banks to lend.

After the announcement, the market for these highly rated mortgage securities showed signs of improvement.

Economists and analysts largely praised the move, saying it goes further in directly addressing current problems than simply cutting a short-term interest rate, which adds to inflationary fears.

"They may have hit the right spot in the marketplace where the help was needed," said Bill Tedford, fixed-income strategist at Stephens Capital Management.

The Fed action represented a change in a long-standing but little-known program called a term securities lending facility. The program will allow large investment banks to trade in securities issued by Fannie Mae and Freddie Mac and other AAA-rated mortgage-backed securities that are not on a watch list to be downgraded. It will allow financial institutions to borrow Treasurys for 28 days, not just overnight.

The action was the second by the Fed in five days to try to get markets for mortgage-backed securities and other generally safe debt products functioning again. On Friday, the Fed said it would inject an additional $200 billion into the banking system through a different form of auction, known as a term auction facility. Those measures were also meant to help liquidity return to troubled world credit markets, but they were targeted at commercial banks, not investment banks.

The Fed had been preparing the move for weeks, taking action only after the markets continued to worsen in recent days.

"The mortgage market has just been locked up," said Craig Elder, fixed-income senior analyst at Robert W. Baird & Co. "I'm not sure if it solves all of the problems, but I think it should free up a considerable amount of liquidity."

While welcoming the Fed move, analysts were guarded in their enthusiasm. Since the credit crunch began roiling global markets last summer, the central bank has carried out a series of steps that temporarily calmed markets only to see investor confidence plunge again as new problems emerged.

"It's one step in the right direction in promoting liquidity, yet there certainly are some hurdles over the near term," said Joe DiCenso, fixed-income strategist at Lehman Brothers.

One of those hurdles may come next week, when first-quarter earnings start to be released by Wall Street firms. Goldman Sachs and Lehman Brothers report next Tuesday, followed by Bear Stearns on Thursday.

Analysts are projecting additional losses on top of the multibillion-dollar write-downs already suffered by financial institutions. But if the losses are substantially more than investors anticipate, panic could return to the credit market, analysts said.

"We think that this improvement hopefully will endure, but we probably have to get through next week and to the end of March for more confirmation of that," DiCenso said.

In announcing the program, the Fed also extended agreements with central banks in Switzerland and the European Union that allow them to borrow billions of more dollars from the Fed and inject this money into their financial systems.

The Fed resisted calls by some on Wall Street for it to simply buy up mortgage-backed securities to help that market gain its footing again. That's because the central bank does not want to be in a position of propping up prices for any given asset, staff members said, but rather is focused on making markets function smoothly.

Irwin reported from Washington.