Fed cut revives wilted market

The Baltimore Sun

WASHINGTON -- The Federal Reserve's surprise cut in a key lending rate yesterday calmed roiling financial markets at least temporarily, but it probably isn't enough to eliminate fears that more bad news lies ahead. Consequently, interest rate cuts are likely in the weeks and months ahead, analysts said.

The Fed cut its discount rate - what it charges banks for loans - from 6.25 percent to 5.75 percent. That sent the Dow Jones industrial average soaring by more than 300 points in early trading. After drifting back down, the Dow surged again late in the day, closing up 233 points to a finish of 13,079.

In a statement, the Fed's policy-setting Federal Open Market Committee warned that quaking financial markets, tight credit conditions and spreading uncertainty "have the potential to restrain economic growth going forward. ... The committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets."

The message to Wall Street - the Fed will ride to the rescue.

"Bluntly, I think they're realizing this turmoil can impact the economy and they've got to move accordingly," said David Wyss, chief economist for Standard & Poor's.

Banks generally don't use the Fed's discount window much because funds typically are available cheaper elsewhere, but yesterday's action made it easier for troubled lenders to borrow from the Fed as a last resort. The Fed also allowed repayment to stretch out to 30 days or beyond; usually discount loans are repaid in 14 days.

Yesterday's action raised hopes that the Fed would next cut the federal funds rate - which banks pay each other for overnight loans - when it next meets on Sept. 18. The Fed has held that rate steady at 5.25 percent since June 2006.

Banks use the federal funds rate as a benchmark for loans to consumers and businesses. A rate cut would help spur the economy.

It has been 27 years, Wyss said, since the Fed moved the discount rate without also moving the fed funds rate. "What it does is, it buys them 30 days to the next FOMC meeting," he said.

"I would anticipate that the Fed is going to cut the fed funds rate by 50 basis points, most probably at the Sept. 18 meeting," agreed Nigel Gault, an economist with the consultancy Global Insight in Lexington, Mass. Fifty basis points is half a percentage point.

Housing is at the center of today's Wall Street crisis. Lenders gave millions of subprime loans to unqualified borrowers with weak credit histories. The loans were bundled together and sold to investors as mortgage bonds.

Now fears about huge defaults on subprime mortgages have spread to virtually all home loans and the securities based on them. It's not clear how many bad loans are held by investment banks and mortgage lenders. That uncertainty is at the heart of fears on Wall Street - that like the 1989 savings and loan crisis, many lenders could be on shakier ground than they admit.

Because of widespread fear that bad loans are far more extensive than is yet known, investors are shunning the purchase of new debt, so finance is drying up for business expansion. That threatens the broader real economy beyond Wall Street.

Many analysts say the crisis isn't over yet.

"Make no mistake: The Fed's spectacular move on Friday is no panacea," Warren Buffett, known as the sage of Omaha, says.

" 'The hangover is commensurate with the binge.' And lenders have indeed been on a binge that has produced a massive hangover," wrote Irwin M. Stelzer, director of economic studies at the Hudson Institute, a conservative think tank, in an article published yesterday on The Weekly Standard's Web site.

"There are still lots of securities out there that are backed with assets of unknown value; lenders are still skittish, and not eager to finance new mortgages; many lenders are going to have to write down the value of assets they have on their books at values far above what they can fetch in the market," Stelzer wrote.

These fears have undermined the market for short-term notes issued by corporations to finance expansion and other business needs.

"Apart from the aftermath of 9/11, this is the largest percentage decline [of outstanding commercial paper] since September 1982," Goldman Sachs researchers wrote yesterday.

Current Wall Street woes resemble the unraveling savings and loan crisis that helped trigger a recession in 1990-1991. Back then, weakly regulated lenders had a huge bad-loan portfolio largely hidden from public view. Those bad loans eventually led to a government bailout costing more than $175 billion.

By cutting the discount rate, the Fed threw a lifeline to large, struggling mortgage lenders such as Countrywide Financial Corp., which underwrites nearly one in five home mortgages. Countrywide, which has a securities subsidiary, is trying to stave off bankruptcy, unable to sell its loans in the secondary mortgage market.

The discount-rate cut followed the Fed's injection of more than $50 billion in cash into the banking system over the past week to ensure that lenders had enough cash for short-term needs.

Some analysts, including former Fed Governor Lyle Gramley, believe that the next move should come from the Bush administration, not the Fed.

Gramley argues that the administration should lift caps on government-sponsored home-finance enterprises Freddie Mac and Fannie Mae so they can purchase existing home loans and bundle them with safer mortgage-backed securities.

"If those caps were lifted temporarily, then Fannie and Freddie could perform their historic role of providing liquidity to the market, which desperately needs it," Gramley said.

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