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Global Stocks Sink as Crisis Spirals; Fed Moves to Thaw Credit Markets
Dow Closes Below 10,000 Despite Late Rally

By Steven Mufson and Neil Irwin
Washington Post Staff Writers
Tuesday, October 7, 2008

With financial markets in near-meltdown, governments around the world scrambled to find new ways to infuse vast amounts of cash into banks and even directly to companies to help resuscitate the global financial system.

The Federal Reserve last night was weighing a plan that would in effect make it a major funder of a wide range of U.S. businesses facing imminent cash shortages. The Fed also said yesterday that it would push $900 billion into the U.S. banking system, a six-fold increase in its program of lending money to banks.

The measures followed similar efforts by other central banks and governments around the world over the weekend and yesterday to get financial institutions to stop hoarding money and start lending to one another and to their customers.

It wasn't enough. Stock markets began a steep tumble in Asia, where most national markets were down considerably, and then declines accelerated in Europe on fears of new bank failures. The French stock index tumbled 9 percent, the German index dropped 7 percent and the British benchmark index fell nearly 8 percent. Russia was off nearly 20 percent.

In the United States, the Dow Jones industrial average fell 3.6 percent, closing below the 10,000 level for the first time since 2004. It had been down nearly twice that at one point before staging a late rally.

With the financial crisis now engulfing most of the developed world, a meeting scheduled for later this week in Washington of the International Monetary Fund and World Bank will probably turn into a summit that could provide a forum for coordinated action.

But there was little sign of coordination among European leaders, who could not agree over the weekend on a common approach to the crisis and who yesterday bickered over what sorts of protections they would offer investors and institutions.

While Europe struggled to stop new bank failures, in the United States, alarm has increasingly focused on the commercial paper market, where all sorts of businesses and local and state governments turn for money for day-to-day operations. For the past week, that market has been nearly paralyzed, and yesterday, the cost of such borrowing soared.

"The big gorilla is really liquidity," said Edward Liebert, treasurer of Rohm & Haas and chairman of the National Association of Corporate Treasurers, 100 of whose members discussed the crisis in a conference call Thursday.

Last night, the Fed was drawing up plans to set up a special fund that would buy short-term commercial paper. The purchases would benefit banks as well as non-financial companies.

The fund would be financed by a loan from the Fed, and any losses would probably be covered by the Treasury using its new $700 billion bailout package. Fed and Treasury lawyers were hammering out details last night.

Purchasing commercial paper through the new special entity would increase risks for the Treasury, and ultimately taxpayers, while potentially relieving companies of the downside risk of bad behavior, financial experts said. One senior U.S. bank executive said it was "like taking the fire sensors out of the building."

One benefit of such an action is that it would free up money for lending and lower the interest rates banks pay to borrow money to conduct business. Yesterday, the rate at which banks lend to one another -- the London interbank offered rate, or Libor -- was 4.3 percent for a three-month loan. In normal times, it would be not much higher than the 2 percent bank lending rate set by the Fed. The premium is a measurement of the mistrust among banks and translates into higher rates for businesses and consumers, if they can get loans at all.

Another step the Fed could take to try to jolt the financial system out of its current torpor would be to cut its target for short-term interest rates. The federal funds rate is currently 2 percent, and many financiers on Wall Street argue that an emergency rate cut, as early as today, would help the situation.

As recently as last week, there was no consensus at the Fed on whether additional rate cuts would make sense. Some leaders of the central bank worried that they would not serve their intended purpose of stimulating the economy as long as the credit markets were clogged. They feared that a rate cut could cause the dollar to drop and commodity prices to rise.

But in recent days, as the financial crisis has become more severe, an emergency rate cut, perhaps coordinated with other large countries, has become more plausible. Fed Chairman Ben S. Bernanke is set to deliver a speech today that will indicate his current thinking on rates.

Early today, Australia's central bank cut the country's benchmark lending rate by a full percentage point, to 6 percent, but the Bank of Japan left its key interest rate unchanged at 0.5 percent.

The deteriorating credit and economic picture has provoked an increasing amount of criticism of U.S. and European central bankers and has spread anxiety in financial markets that even the lenders of last resort might be stretched to their limits.

"The Federal Reserve balance sheet is about $1.2 trillion," said David Shulman, senior economist at the UCLA Anderson Forecast. "But we have an $11 trillion mortgage market, a $54 trillion credit-default-swaps market. The central banks are nowhere near large enough to handle this problem right now."

Edwin Truman, a senior fellow at the Peterson Institute for International Economics and long-time senior Fed official for international affairs, said that the Fed's rate cuts have had much less impact than intended and that the Fed needed to take action that would also bring down Libor rates, which are more closely linked to the rates businesses and consumers pay.

Economists also differ over the threats of inflation or deflation. Some fear inflation as a result of lower interest rates and a flood of money, much of it simply printed by the U.S. government, pushed into the financial system. That would have the effect of reducing the value of U.S. debts, harming countries like China but benefiting Americans.

Other economists say the world economy is on the brink of such a severe economic contraction that inflation should be far down the list of concerns. Investors and traders in commodities share that worry; yesterday, fears of global recession pushed crude oil prices down $6.07 to settle at $87.81 a barrel.

"We're facing the worst global downturn since the early 1980s, and you just don't have inflation in that environment," Truman said.

"The key thing is to restore confidence," said Liebert, the corporate treasurer. "Bernanke's been very proactive with the rescue plan, but investors have to feel that the worst is over. The headlines from Europe are unsettling the market now. A cut in interest rates right now are not going to help too much. The cost of capital is being inflated by the perception of risk."

In past financial crises in small countries, the IMF has often rescued the situation with a combination of capital and reassurance to investors and businesses. But the United States is too big for the IMF to bail out, and besides, a senior World Bank official said, the United States doesn't need more capital. Instead, the IMF will probably look for ways it can intervene in smaller industrial and developing economies to combat the effects of financial contagion.

"I think our role in this crisis is different from previous crises in that it started in the center of the financial system rather than the periphery," said Masood Ahmed, director of external relations at the IMF. He added, "in the end, this crisis is going to be sorted out by the policymakers of individual countries."

Staff writer Anthony Faiola contributed to this article.

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