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Fed Takes Broad Action to Avert Financial Crisis
Central Bank Backs Sale of Bear Stearns, Cuts Key Interest Rate, Extends New Credit

By Neil Irwin and David Cho
Washington Post Staff Writers
Monday, March 17, 2008

The Federal Reserve took dramatic action on multiple fronts last night to avert a crisis of the global financial system, backing the acquisition of wounded investment firm Bear Stearns and increasing the flow of money to other banks squeezed for credit.

After a weekend of marathon negotiations in New York and Washington, the central bank undertook a broad effort to prevent key financial players from going under, including the unprecedented offer of short-term loans to investment banks and an unexpected cut in a special bank interest rate.

As part of the deal, J.P. Morgan Chase, a major Wall Street bank, will buy Bear Stearns for a bargain-basement price, paying $2 a share for an institution that still plays a central role in executing financial transactions. Bear Stearns stock closed at $57 on Thursday and $30 on Friday. J.P. Morgan was unwilling to assume the risk of many of Bear Stearns's mortgage and other complicated assets, so the Federal Reserve agreed to take on the risk of about $30 billion worth of those investments.

The Fed "is working to promote liquid, well-functioning financial markets, which are essential for economic growth," Chairman Ben S. Bernanke said in a conference call with reporters last night. Treasury Secretary Henry M. Paulson Jr., who was deeply involved in the talks though not a formal party to them, indicated support for the actions.

The Fed's moves were meant to reverse a rising tide of panic that has buffeted Wall Street as banks and other institutions have found it increasingly difficult to get credit. While the steps may head off a generalized run on Wall Street banks, the central bank's intervention looks unlikely to calm the recent volatility on markets as the trading week begins.

Asian markets opened sharply lower, with the Japanese Nikkei index down more than 4 percent at the end of its morning trading session today. Hong Kong's Hang Seng index dropped more than 5 percent in early trading; markets in Australia and New Zealand were also down. And the dollar was down sharply, hitting a new low against the euro and the lowest level against the yen since 1995.

The extraordinary measures were made necessary, in the view of the policymakers, by the most dire threat facing world financial markets in years. Bear Stearns, in particular, was confronting a run on the bank as investors were too fearful of the future to make even overnight loans to the nation's fifth-largest investment firm. If it had been allowed to fail, senior officials believed, it would have created a cascading crisis of confidence that could well have brought down several other leading firms and dragged world markets with them.

Policymakers weighed that risk against the risk that their actions would create "moral hazard," or greater willingness of companies to take inappropriate chances. The officials stressed that their efforts were meant not to save shareholders of Bear Stearns or any other company but to keep markets from collapsing.

J.P. Morgan Chase, one of the few Wall Street firms to receive only modest scars from the meltdown in the market for U.S. mortgage loans and other debt, agreed to buy Bear Stearns just two days after making an emergency loan to the investment firm. Leaders at the Fed and the Treasury strongly encouraged the firms to execute the transaction -- and to announce before Asian markets opened today -- so that investors would be comfortable doing business through the company.

Paulson welcomed the deal. "Last Friday, I said that market participants are addressing challenges and I am pleased with recent developments. I appreciate the additional actions taken this evening by the Federal Reserve to enhance the stability, liquidity and orderliness of our markets," he said in a statement.

J.P. Morgan was happy to buy most of Bear, but wanted no part of its portfolio of complicated mortgage and other investments. Paulson and Bernanke were personally involved in the talks and told J.P. Morgan Chase executives that they could not buy just the most valuable pieces of Bear Stearns because there were global financial issues at stake.

Fed leaders, eager for the transaction to happen and wary of anything that would result in a fire sale of those risky assets, agreed to finance those assets and then sell them in an orderly way. In effect, the Fed has taken on the risk that these assets might be less valuable than anyone currently realizes.

This has been a remarkably fast fall for a titan of Wall Street. It took 85 years to build Bear Stearns and four days for it to dissolve. But the troubles for Bear Stearns may not be over. Shareholder lawsuits could be filed against the firm if investors suspect Bear Stearns officials knew Friday that bank's value practically evaporated but failed to disclose that information publicly.

The trio of Fed actions aim to ensure that other top Wall Street firms do not experience a similar bank run.

The central bank will now make it possible for investment banks to borrow money as long as they put up collateral. The Fed in effect is offering to be a lender of last resort for 20 major Wall Street firms, a role it has previously played only for commercial banks.

Since the central bank was created in 1913, it has served as a lender of last resort for ordinary banks, allowing them to post high-quality loans at a "discount window" in exchange for cash.

Last night, it announced a new provision that will in effect do the same for major investment firms. Starting today, and lasting for at least six months, this new operation will allow "primary dealers," which are 20 major Wall Street firms, access to cash in exchange for assets in which the market is not currently functioning.

And by lowering the discount rate, borrowing that money will be cheaper for both commercial banks using the discount window and investment firms using the new initiative.

The reduction in the discount rate -- a quarter percentage point cut to 3.25 percent -- will lower the rate banks are charged for emergency loans. That rate does not directly affect the cost for businesses and consumers to borrow money.

The five Fed governors voted unanimously to approve the actions, stating that the moves were designed to "bolster market liquidity and promote orderly market functioning." They are the latest in a series of unconventional actions taken by the central bank in the past six months.

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