As crisis deepens, Fed steps up role
The collapse of Bear Stearns sends the central bank scrambling to ease fears.
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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."
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."