Moves by Fed, Europeans Fail To Calm Investors
Dow Falls 5% Despite Hint at Rate Cut, Massive Efforts to Loosen Credit

By Neil Irwin
Washington Post Staff Writer
Wednesday, October 8, 2008

Economic policymakers around the world again threw vast amounts of money into their efforts to stabilize chaotic financial markets yesterday, but even hints of a long-anticipated interest rate cut in the United States failed to halt Wall Street's slide.

Aggravating the market downturn was a gloomy assessment from Federal Reserve Chairman Ben S. Bernanke, who said in a speech that the deepening financial crisis had darkened the economic outlook. Because of those conditions, he signaled that the Fed might soon cut interest rates, a step that in normal times would make it easier for banks or investors to borrow.

But in these times, even that wasn't enough to cheer the markets.

They remain roiled, as investors were concerned that banks and real estate companies are in more trouble than they had thought, following Monday's announcement that Bank of America -- until now considered a rock of the U.S. financial system -- would cut its dividend and seek to raise new capital.

The Dow Jones industrial average declined for a fifth consecutive day, falling 508 points, or 5.1 percent. The Standard & Poor's 500-stock index, a broader measure of the market, dropped 60.66, or 5.7 percent; it is down 15 percent so far this month. Separately yesterday, the rate that banks charge for loans to each other, a crucial measure of the flow of credit, rose.

In Europe, markets were flat after authorities in Britain and on the Continent moved to shore up their banking systems. The British government was preparing an emergency plan that could inject tens of billions of dollars into its banks. One of the biggest, Royal Bank of Scotland, lost more than $17 billion of its market value as its shares dropped 39 percent.

The 27-nation European Union, meanwhile, raised its protections on bank savings, and finance ministers of its member nations pledged to better coordinate their response to the financial crisis.

The troubling signs came despite a morning announcement that the Fed will buy up commercial paper, the short-term debt that funds the daily operations of banks and ordinary businesses. In a bold new attempt to jump-start the lending that is the lifeblood of American business, the central bank said it would create a special entity to purchase this short-term debt.

The investors that normally snap up those relatively low-risk investments, such as college endowments and money-market mutual funds, aren't doing so. That is causing stresses throughout the financial system that are damaging the overall economy. So the Fed has moved to essentially funnel cash to companies -- up to the entire universe of $1.3 trillion of high-quality commercial paper that has been issued.

"The central bank is finally starting to get aggressive," said Drew Matus, a senior economist at Merrill Lynch. "Now they're trying to keep things functioning until the Treasury plan starts up," he said, referring to the $700 billion fund to buy up troubled assets from financial firms.

Yesterday's action by the Fed could even lay the groundwork for future interventions in credit markets, should the troubles deepen.

"It could be expanded for different types of securities," said Michael J. Feroli, a U.S. economist at J.P. Morgan Chase. "Today Bernanke said they're going to continue to be aggressive and innovative, and I don't expect that to slow down anytime soon."

In his speech yesterday afternoon, Bernanke indicated that the Fed could cut interest rates soon to try to shield the economy against the fallout from the financial crisis. Prices in futures markets indicate that investors are nearly certain rates will be cut at the Fed's Oct. 28-29 policymaking meeting, if not before.

The combination of recent sour economic data and the crisis "suggests that the outlook for growth has worsened and that the downside risks to growth have increased," Bernanke told the National Association for Business Economics yesterday. As a result, the central bank "will need to consider whether the current stance of policy remains appropriate," a clear sign that rate cuts are on the table.

Under Bernanke, the Fed has cut rates between regularly scheduled meetings just once, this past January. But Bernanke used milder language yesterday than he did in an early January speech that foreshadowed that cut, suggesting there is no certainty the Fed will move as quickly and aggressively as many Wall Street analysts are forecasting.

In particular, some Fed leaders have indicated in speeches that they think that rate cuts won't have their intended impact -- of lowering borrowing costs and thus stimulating the economy -- so long as world credit markets remain a mess. And they worry that the price of oil has been so volatile lately that rate cuts could end up hurting Americans' purchasing power by driving the price of oil up and the value of the dollar down.

The financial crisis strikes at the heart of Americans' ability to continue buying the things they need, Bernanke said in his speech.

"Even households with good credit histories are now facing difficulties obtaining mortgage loans or home-equity lines of credit," Bernanke said. "Banks are also reducing credit card limits, and denial rates on automobile loans reportedly are rising."

Offering fresh evidence of the depth of the problem, the Fed released data yesterday indicating that the amount of consumer debt Americans have outstanding had its first monthly decline in a decade in August. And that was before the credit crisis deepened in September and October.

Although a rate cut would be aimed at encouraging overall economic growth, the new Fed action on commercial paper is designed to get more at the nub of the problem, a crisis of confidence among banks and other lenders.

The Fed is using emergency authority it was granted during the Depression to lend to any "individual, partnership or corporation" in "unusual and exigent circumstances." It used that authority two other times this year -- to rescue Bear Stearns and take over American International Group. This time, for the commercial paper program, the Treasury Department will help provide funding.

In previous lending programs this year, the Fed has loaned only against strong collateral. But now the Fed will even take on "unsecured" debt, or that which is backed only by the faith of the company borrowing money. It will require insurance fees on companies borrowing money with unsecured debt to protect against losses.

Critically, the Fed will buy debt that is for three-month terms. Lately, a wide variety of companies have been able to borrow money only overnight. That has put them in a precarious position of having their fates decided every evening, as lenders must again review whether to renew the loans.

By having the government ready to buy slightly longer-term debt, that uncertainty should be diminished, Fed officials are hoping.

The Fed entity will pay interest rates that are lower than the extremely elevated rates of recent days, but still higher than what the companies could borrow at in normal times. That way, once financial conditions return to normal, the companies needing money will naturally migrate back to private markets so as to get lower borrowing costs.

"It seems like the program is well designed to allow the normal functioning of the commercial paper market to resume," said Matus, the Merrill Lynch economist.

In the speech yesterday, Bernanke for the first time defended his decision not to intervene to save Lehman Brothers, the investment bank that filed for bankruptcy protection last month, helped trigger a worsening of the crisis.

It boils down to: The Fed had little choice.

"We determined that either facilitating a sale of Lehman or maintaining the company as a free-standing entity would have required a very sizable injection of public funds -- much larger than in the case of Bear Stearns -- and would have involved the assumption by taxpayers of billions of dollars of expected losses.

"Neither the Treasury nor the Federal Reserve had the authority to commit public money in that way," Bernanke said. He drew a contrast with the Bear Stearns and AIG bailouts, in which the Fed made loans that it fully expects to be paid back.