As crisis deepens, Fed steps up role

The collapse of Bear Stearns sends the central bank scrambling to ease fears.

By , Staff writer of The Christian Science Monitor

In the wake of the collapse of Bear Stearns, a top investment bank, the Federal Reserve is struggling to reestablish confidence in America's financial system.

The US central bank is guaranteeing loans, taking questionable loans off the books of banks, and dropping interest rates at a near-record pace. Despite the Fed's efforts, the credit markets remain wary. Most economists agree that the Fed has now moved from crisis prevention to crisis management, trying to limit any cascading effect from problems on Wall Street.

"This is like nothing I have ever seen before in 50 years of looking at the economy," says Lyle Gramley, a former Fed governor. "We are in a very serious situation."

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To try to limit the damage to the US financial system, the Fed is expected to drop interest rates by another three-quarters of a percentage point on Tuesday. Over the weekend, it lowered the discount rate, the rate it charges banks to borrow directly from the Fed, by one-quarter of a percentage point.

"The Fed is doing what it must to keep a meltdown in the financial markets from generating a meltdown in the economy," says Mr. Gramley, now a consulting economist at Stanford Group in Washington. "They are being very innovative and aggressive."

One of Gramley's concerns is that banks will continue to tighten their lending despite the easing by the Fed. This could spill over to Main Street in the form of yet more foreclosures. In addition, home prices would continue to decline.

No question, the Fed is dealing with some daunting challenges in the financial markets. Last week, lenders began to question the financial underpinnings of Bear Stearns, which borrows heavily to finance its operations. Even though Bear Stearns had $14 billion in cash on hand, it was not enough to keep the company afloat. Instead, JPMorgan Chase has agreed to buy Bear Stearns for $2 a share, or about $236 million.

In an unusual move, the Fed has agreed to take on its own books some $30 billion in mortgage securities or other less-than-liquid assets held by Bear Stearns.

"The Fed is treating Bear Stearns like a failed bank," says David Wyss, chief economist at Standard & Poor's in New York. "They are trying to restore some kind of functioning to the financial markets."

The Fed is also trying to give securities firms some breathing room. Over the weekend, in an unprecedented move, it said securities dealers could borrow for up to six months, the same way commercial banks can borrow from the Fed.

Echoing savings-and-loans failures

The Fed's actions remind some analysts of the turbulent period in the 1980s and 1990s, when over 1,000 savings and loans failed and their assets were taken over by the Resolution Trust Co.

"It's not that far from the Resolution Trust situation," says Bob Eisenbeis, chief monetary economist at Cumberland Advisors in Vineland, N.J., and a former senior official at the Atlanta Fed. "Now it's the Federal Reserve putting the taxpayer on the hook."

President Bush, who has been opposed to taxpayer bailouts of individuals in danger of foreclosure, hailed the Fed's actions Monday. "We've taken strong decisive action," Mr. Bush said at the White House after meeting with Treasury Secretary Henry Paulson and other members of his economic team.

Some investors, however, questioned the rationale of the Fed taking some of Bear Stearns's assets off its books.

"When the Fed does this, it is sticking it to American savers or anyone with US currency," says Peter Schiff, president of Euro Pacific Capital in Darien, Conn. "There are more brokerage houses with problems, and the Fed is just monetizing this thing." Still, Bear Stearns's disappearance as an investment bank shook financial markets. After a day of seesaw trading, the Dow Jones Industrial Average closed up 21.16 points, to 11972.25.

The firm's meltdown makes investors nervous, says Bob McIntosh, chief economist at Eaton Vance in Boston. "Here is another firm that said two weeks ago they had no problems, and now they are gone," he says. "Credibility just does not exist: Nothing would surprise anyone."

If the Fed reduces interest rates by three-quarters of a percentage point Tuesday as expected, it will have lowered short-term interest rates by 3 full percentage points since last September. That would be the fastest seven-month reduction since 1981, when then-Fed Chairman Paul Volker lowered rates by 6 percentage points in that time period. "It's a pretty rapid decline but not unprecedented," says Bob Brusca of Fact & Opinion Economics in New York.

However, Gramley is concerned that the economy is not responding to the Fed's interest-rate moves. "In all [post-World War II] recessions, you could be sure if the Fed hit the gas pedal, the economy would turn around," he says. "Since last September, the Fed has been stepping on the gas pedal, but credit is not more available, but less. The market is not up but down."

More home foreclosures?

The risk of the economy not responding to the Fed's stimulus is daunting, Gramley says. With banks continuing to tighten credit standards, he worries the housing market will sink further. "Foreclosures will continue to rise, and home prices will be further depressed, and since homes are the underlying collateral for many loans, the problem becomes worse," he says. "This will require innovative thinking."

In fact, some Fed watchers worry that more is being done for Bear Stearns than homeowners. "Of all the investment houses, Bear Stearns was the one most deserving of going under because of the subprime crisis, both for its ownership of a subprime lender and its work packaging those loans," e-mails Kurt Eggert, a law professor at the School of Law at Chapman University in Orange, Calif., and a former member of the Federal Reserve Board's Consumer Advisory Council. "The Feds are doing more to help Bear Stearns than the borrowers facing foreclosure because of Bear Stearns's actions."

• Material from the Associated Press was used in this report.

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