Fed invokes Depression-era emergency powers

October 7, 2008 4:53:03 PM PDT
The Federal Reserve moved swiftly to break through a credit clog that is imperiling the economy, saying Tuesday it would buy massive amounts of short-term debt and hinting that it may cut interest rates. [CHECK THE MARKETS: Get the latest numbers from Wall Street]
[FINANCIAL CRISES: From the Depression until today]
[DARK DAYS AHEAD: Bernancke's assessment]

Wall Street was unimpressed. The Dow Jones industrials shed more than 500 points.

Fed Chairman Ben Bernanke warned that the financial crisis has not only darkened the country's current economic performance but also could prolong the pain.

"The outlook for economic growth has worsened," Bernanke said in a speech at the annual meeting here of the National Association for Business Economics.

His more gloomy assessment appeared to open the door wider to an interest rate cut on or before Oct. 28-29, the central bank's next meeting, to brace the wobbly economy. The Fed's key interest rate now stands at 2 percent.

President Bush, saying the economic meltdown has brought tough times for many Americans, pledged that "we're going to come through this."

"Have faith, this economy is going to recover over time," Bush said in a speech at an office supply company in the Washington suburb of Chantilly, Va. "I wish I could snap my fingers and make what happened stop. But that's not the way it works."

The president earlier reached out to European leaders to urge coordination on efforts to solve the financial crisis spreading around the globe. The White House said Bush was open to the idea of a leaders' summit on the economic upheaval.

Stocks slumped, however, as investors focused on Bernanke's warnings and worries about the weakness of financial companies. Bank of America Corp. reported its third-quarter profits fell 68 percent. The three major U.S. stock indexes all fell more than 5 percent a day after a huge selloff Monday put the Dow below 10,000 for the first time in four years.

The statements came against a backdrop of increasing concern that a global recession is rapidly developing. There is growing pressure for the U.S. government to do more beyond the $700 billion financial bailout package President Bush signed into law Friday.

To that end, the Fed invoked Depression-era emergency powers to begin buying commercial paper -- short-term funding that many companies rely on to pay their workers and buy supplies.

The government's bailout package is aimed at thawing lending by buying rotten mortgages and other bad debts from banks and other financial institutions. By getting these bad debts off bank's balance sheets, they might be in a better position to raise capital and more willing to lend to each other and to customers.

Tight credit has made it increasingly difficult and expensive for companies to raise money to fund their operations.

"The expansion of Federal Reserve lending is helping financial firms cope with reduced access to their usual sources of funding," Bernanke explained.

Commercial paper is a way of borrowing money for short periods, typically ranging from overnight to less than a week.

In more normal times, about $100 billion of these short-term IOUs were outstanding at any given time, sold by companies to buyers that included money market mutual funds, pension funds and other investors. But this market has virtually dried up as investors have become too jittery to buy paper for longer than overnight or a couple of days.

The unstable situation has left many companies vulnerable. The notion under the plan is for the government to provide a "backstop" that would give companies a new place to get cash, the Fed said. The action makes the Fed a crucial source of credit for nonfinancial businesses in addition to commercial banks and investment firms.

Credit markets eased slightly, however, after the Fed's move raised hopes it would quickly relieve the short-term funding problems plaguing some companies.

European stocks were mixed on hopes that central banks around the globe would coordinate on rate cuts. In Britain, the FTSE 100 index ended 0.4 percent higher, France's CAC-40 index in Paris gained 0.6 percent higher, but Germany's DAX slipped 1.1 percent.

Iceland is facing the prospect of bankruptcy, according to the Prime Minister Geir H. Haarde, after its banks went on a buying spree across Europe, accumulating massive debts in the process.

The Fed said it is creating a new entity to buy three-month unsecured and asset-backed commercial paper directly from eligible companies. It hopes to have the program up and running soon, Fed officials said.

Fed officials said they'll buy as much of the debt as necessary to get the market functioning again. They refused to say how much that might be, but they noted that around $1.3 trillion worth of commercial paper would qualify.

"The commercial paper market has been under considerable strain in recent weeks as money market mutual funds and other investors" have become increasingly reluctant to buy commercial paper, especially longer-dated maturities. As the market for commercial paper shrank, the Fed said rates on the longer-term debt "increased significantly," making it more expensive for companies to borrow.

The Treasury Department, which worked with the Fed on the program, said the action is "necessary to prevent substantial disruptions to the financial markets and the economy."

The Treasury will provide money to the Federal Reserve Bank of New York to support the new program, the Fed said. Fed officials would not say how much but believed it would be substantial. The money would not come from the $700 billion financial bailout President Bush signed into law on Friday.

If a company's commercial paper is not backed by assets or other forms of security acceptable to the Fed, the company could pay an upfront fee, the central bank said. The amount of such a fee has not yet been determined.

The Fed said it hoped its effort would jolt the commercial paper market back to life.

"This facility should encourage investors to once again engage in term lending in the commercial paper market," the Fed said. That should eventually spur financial companies to lend to each other and to their customers, including consumers, the Fed said.

The Fed said it planned to stop buying commercial paper on April 30, 2009, unless the Federal Reserve board agrees to extend the program. The Fed created a separate entity to pool and hold the commercial paper it buys. The Fed said this should allow the central bank to more easily manage the program and better control risk.

There was $1.61 trillion in outstanding commercial paper, seasonally adjusted, on the market as of last Wednesday, according to the most recent data from the Fed. That was down from $1.70 trillion in the previous week. Since the summer of 2007, the market has shrunk from more than $2.2 trillion.

As the number of failed banks has gone up sharply this year, Sheila Bair, head of the Federal Deposit Insurance Corp., wants to boost fees to financial institutions to replenish the insurance fund that backs the nation's deposits. The increase would double the average paid by U.S. banks and thrifts next year.

The lending lockup is a key reason why the U.S. economy is faltering. Unable to borrow money freely or forced to pay a high cost to borrow, employers are cutting jobs and reducing capital investments. Consumers have retrenched.

With just four weeks to go before the presidential election, the economy is issue No. 1 for voters.

Republican candidate John McCain and his Democratic rival Barack Obama will meet for their second debate Tuesday night at Belmont University in Nashville, Tenn.

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