Federal Reserve intervenes and market soars

Federal Reserve intervenes and market soars
By Kevin G. Hall | McClatchy Newspapers
Posted on Tuesday, March 11, 2008

WASHINGTON ?- The Federal Reserve announced Tuesday that it will provide up to $200 billion in short-term loans, accepting a wide range of mortgage bonds as collateral in a bid to boost credit markets, keep housing finance alive and avoid a recession.

In a short statement, the Fed noted the increasing "pressures in some of these markets" and announced the new loans and a coordinated loan-financing effort with the central banks of Canada, England, Switzerland and the European Union.

Stocks, which had slumped over the past three sessions, soared throughout the day on news of the Fed's action. The Dow Jones Industrial Average closed up 416.66 points. The S&P 500 was up 47.28 and Nasdaq jumped 86.42 points.

"The Fed's action is creative and laudable and should help alleviate the worst of the liquidity problems currently plaguing the financial system," said Mark Zandi, the chief economist of Moody's Economy.com, a forecaster in West Chester, Pa.

Although the announcement was about credit markets, mortgage bonds are at the heart of today's problems. Mortgage lending has virtually seized up, and the mortgage-finance problems have spread more broadly to credit markets in recent weeks, affecting lending for cars, college loans and corporate finance.

While Wall Street seems pleased with the Fed's action, some think that it might not be enough to fix the fiscal troubles that are roiling the housing and credit markets. Some even have suggested more direct government intervention much like what occurred in the savings and loan crisis of the late 1980s, in which taxpayers eventually took ownership of 35,000 properties worth $10 billion.

In Tuesday's bid to ease market fears, the Fed will begin a series of weekly auctions March 27 in which it provides 28-day loans to banks and securities dealers. It will swap treasury bonds from its vast reserves for a wide range of collateral, including mortgage bonds, also called mortgage-backed securities.

The Fed is trying to lead by example, recognizing that investors are afraid to touch any financial instrument tied to the U.S. housing sector and hoping to show that there's nothing to fear but fear itself.

To that end, the Fed will accept as collateral the very bonds that financial markets are shunning, both agency-backed mortgage bonds ?- those issued by government-supported entities Freddie Mac and Fannie Mae ?- and the highest-rated mortgage bonds issued by the private sector.

The Fed hopes to shore up confidence in Fannie and Freddie because publicly traded shares of these mortgage giants have plunged in recent months.

Investors are afraid that sinking home prices will make it difficult to determine the real value of mortgage bonds. That's what happened to private-sector mortgage bonds, the source of much of today's turmoil in financial markets.

Investors have reason to fear. Financial markets hold about $4.43 trillion in outstanding pools of mortgage debt sold as bonds by Fannie and Freddie, and about $700 billion of that is on the balance sheets of commercial banks, said Brian Bethune, an economist with forecaster Global Insight in Lexington, Mass.

The Fed's action amounts to a "full-scale assault" to ensure that investor confidence won't erode further, and it might prompt a rebound, Bethune said.

If the Fed is willing to accept mortgage bonds, the reasoning goes, investors will see that they have less reason to be fearful. The Fed also creates a de facto price on the privately issued mortgage bonds, whose value has been hard to determine of late. That's important because without the market for mortgage bonds working properly, banks are wary of issuing new home loans, consumers suffer and home prices fall further.

Usually, the Fed tackles problems in the economy through monetary policy, lowering interest rates to give incentive for more lending to businesses and consumers. But despite lowering its benchmark federal funds rate from 5.25 percent last September to 3 percent in January ?- and it's expected to cut rates further next Tuesday ?- fear continues to grip credit markets, and lending to business and consumers has slowed markedly.

In a conference call, senior Fed staffers explained that they were concerned that financial markets were showing signs of new distress and that lending could seize up if they didn't act.

The move marks the first time that the Fed has accepted mortgage-backed securities as collateral in the short-term loan program, and that offers both risk and reward.

While it's a welcome move, some analysts such as Moody's Zandi think that the government eventually will have to buy problem loans as a bold step to calm markets.

"I suspect (Tuesday's action) won't solve the mounting credit problems in the MBS (mortgage-backed securities) and broader credit markets," Zandi said. "Policymakers will likely have to address those problems more directly in coming weeks and months."

Some lawmakers in Washington are privately weighing the potential creation of an entity like the Resolution Trust Corp., which was formed in 1989 during the savings and loan crisis to purchase assets from insolvent lenders in order to stabilize the real estate market.

Zandi advocates a similar measure now, which would carve out the problem sub-prime loans ?- given to the borrowers with the weakest credit histories ?- and remove them from the broader mortgage market.

These sub-prime loans are packaged into bundles of home loans that are sold as mortgage bonds. The process of identifying which loan bundles were affected has been difficult, and has soured investors more generally to any housing-related financial instrument.