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Fed cuts bank-loan rate, markets rally

The Federal Reserve tried to calm roiling financial markets on Friday, cutting the rate it charges banks for loans from its discount window and warning that falling stocks and increased uncertainty "have the potential to restrain economic growth going forward."

The Fed's unexpected cut in its discount rate from 6.25 percent to 5.75 percent sent the Dow Jones Industrial Average soaring by more than 300 points in early trading, a swing so volatile that it kicked in electronic curbs on trading.

At noon, the Dow was up 132.99 points to 12978.77.

The discount rate is a short-term interest rate that banks pay for borrowing from the Fed. Banks generally don't use it much because funds typically are available cheaper elsewhere, but Friday'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.

By cutting the discount rate, Fed Chairman Ben Bernanke effectively threw a lifeline to large struggling mortgage lenders such as Countrywide Financial, which underwrites nearly one in five home mortgages. Countrywide is trying to stave off bankruptcy, as it is unable to sell its loans into the secondary mortgage market, which has seized up.

On Thursday, Countrywide announced it was drawing on a massive $11.5 billion line of credit from major banks, which analysts said amounted to a final effort to stay solvent. The Fed rate cut gives struggling lenders a means to take out short-term loans if needed.

The Federal Open Market Committee (FOMC), the Fed's policy-setting body, said in a statement Friday morning that "financial market conditions have deteriorated, and tighter credit conditions and increased 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."

Friday's rate cut followed the Fed's injection of more than $50 billion into the nation's banking system over the past week to help ensure that there was ample cash for lenders' short-term needs. Banks had grown wary of lending in light of spreading concerns that bad loans rooted in mortgage markets threatened bank balance sheets.

Historically, a cut in the discount rate foreshadows a cut in the Fed's federal funds rate, which is a benchmark for bank loans to consumers and businesses. Friday's discount-rate cut raised hopes that the Fed's policy-making body could cut its fed funds rate by 50 basis points to 4.75 when it next meets on Sept. 18.

For now, the Fed is taking smaller steps to help calm markets.

"They're doing all this liquidity stuff first, because all that stuff is reversible," said Nigel Gault, an economist with consultancy Global Insight of Lexington, Mass. By "liquidity stuff," Gault referred to the Fed's short-term pumping of money into the banking system, which it is able to reverse quickly once calm is restored.

"You're not going to reverse overnight a formal cut in the federal funds rate," Gault observed.

Housing is at the center of today's Wall Street crisis. Fears about massive defaults on sub-prime mortgages, those given to borrowers with the weakest credit histories, have spread to virtually all home loans. These fears have spread to the market for commercial paper, which are short-term notes issued by corporations to finance expansion and other business needs. 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, which threatens the broader real economy beyond Wall Street.

"Apart from the aftermath of 9/11, this is the largest percentage decline (of commercial paper) since September 1982. Moreover, borrowers who continue to have access to this market have found that they can roll the paper over only for much shorter maturities," said the Goldman Sachs Economic Research Team, in a note Friday to investors. "This has almost certainly caught the eye of Fed officials, and is a problem that ultimately cannot be allowed to persist for long.

The current Wall Street woes resemble the unraveling savings and loan crisis that helped trigger a recession in 1990-91. Back then, weakly regulated lenders had a huge bad-loan portfolio largely hidden from public view. These bad loans eventually hurt the broader economy and led to a government bailout costing more than $175 billion.

Today's financial crisis is rooted in a flood of unsound sub-prime loans to weak borrowers. The loans were bundled together and sold to investors as mortgage bonds. It's not clear the degree to which investment banks and mortgage lenders hold bad loans, and that is at the heart of fears on Wall Street - that like the savings and loan crisis, many lenders could be on shakier ground than they are admitting.

"The question is, is that going to happen again? I don't think so, but I'd love to be more certain," said Irwin M. Stelzer, director of economic studies at the Hudson Institute, a conservative think tank.

Fed moves to provide more cash and credit in the banking system aim to prevent a cash-flow crisis for lenders, especially mortgage lenders. But some prominent economists, including former Fed governor Lyle Gramley, believe that the next move belongs to the Bush administration, not the Fed.

Gramley argues that the administration should lift caps on government-sponsored home-finance enterprises like Freddie Mac and Fannie Mae so they can purchase existing home loans and bundle them together with safer mortgage-backed securities. Lifting the caps on Fannie Mae and Freddie Mac would give a home to the risky assets that are unnerving Wall Street and threatening the broader economy.

"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.

President Bush told economic writers last week that he opposes this sort of bailout for lenders, but failing to lift the caps could turn a housing downturn into a full-blown recession by next year - right in the middle of a presidential election.

"I think the political implications of that are going to dawn on somebody pretty soon," said Gramley.

In trying to prevent the current volatility from snowballing into a recession, the Fed has been walking a fine line. It doesn't want to bail out banks and borrowers that made unsound business decisions, nor does it want to ignore inflation, which is on the high side of its tolerance level.

But the Fed also doesn't want to heed those priorities at the expense of the broader economy, nor risk a complete collapse of the troubled housing market. Credit markets have virtually seized up for home lending, and if left unresolved that could lead to deep drops in home prices, which almost certainly would lead to recession.