Monday, August 11, 2008

Fed Extends Lending Programs as Threats Persist

Move Reflects Worry Over 'Fragile' State Of Financial Market

A year after credit markets seized up, the Federal Reserve is still struggling with the crisis and expanding key lending programs that were designed as temporary measures to nurse the financial system back to health.

The central bank announced Wednesday that it is extending programs through January that allow investment banks to borrow from the Fed. The move is an effort to prevent a worsening in what the Fed described as "continued fragile circumstances in financial markets."

Troubles in the financial world continue to take the Fed deeper into new territory in its effort to prevent a larger credit crunch. The financial sector's weakness is a key reason why policy makers are likely to hold interest rates steady at 2% when they meet next week. A handful of officials are pushing for rate boosts in the near future to get ahead of inflation risks, but most policy makers appear to support staying on hold at least until financial markets can return to a more normal state of functioning. Continued weakness in housing and labor markets also is weighing on many officials.

For the past year, Fed officials have sought to separate their policy actions directed toward financial stability -- emergency lending to financial firms, for instance -- with their monetary-policy role of guiding the economy by setting interest rates. That distinction would allow the Fed to continue its aggressive lending role without being constrained on interest-rate policy if, for instance, it needed to respond to inflation risks.

For now, however, top Fed officials remain especially worried that today's market conditions could deepen the credit crunch by preventing banks from making loans to consumers and businesses. Banks' losses on mortgage loans in particular are wearing down their balance sheets, forcing them to raise large amounts of capital that would allow them to extend credit to consumers. A rate boost now could further aggravate markets while firms are trying to recapitalize. Even though credit markets have improved from their worst points over the past year, they remain far more strained than they were before the credit crisis started last August.

"Healthy economic growth depends on well-functioning financial markets," Fed Chairman Ben Bernanke told lawmakers this month. "Consequently, helping the financial markets to return to more normal functioning will continue to be a top priority of the Federal Reserve."

The Fed's extension of its loan program for securities firms, started in March after the collapse of Bear Stearns Cos., allows the investment banks to take overnight loans directly from the Fed's discount window. That program, known as the primary-dealer credit facility, was set to expire in September.

The Fed extended the program through Jan. 30, though it said "the facilities would be withdrawn should the board determine that conditions in financial markets are no longer unusual and exigent." The move extends the length of the Fed's support to investment banks into the next presidential administration and Congress, which is likely to restart the debate then over whether such firms should get direct lending support.

The Fed's timeline indicates officials believe markets could remain weak, needing a backstop into the beginning of the year. How and when to conclude the program remains in doubt.

"When does it end? It ends a little bit when the liquidity needs start to abate," said Ray Stone of Stone & McCarthy Research Associates. "It's certainly not going to happen soon."

The central bank altered or expanded several programs to address apparent needs of financial institutions and prevent further stress on financial markets.

The Fed extended through January a $200 billion program that allows investment banks to receive 28-day loans of Treasury securities through an auction. In addition, the Fed launched a new program to auction options of up to $50 billion under that program -- the term securities lending facility -- "for exercise in advance of periods that are typically characterized by elevated stress in financial markets, such as quarter ends." That may prevent further market stresses at turning points when firms are closely managing their books, and allows firms to effectively buy insurance instead of carrying the securities over the term. The Fed offered a related program at the turn of the millennium to maintain stability through the Y2K transition.

The Fed carried out a long-sought extension of its auctioned loans for commercial banks. Those will now be available for 84 days in addition to the 28-day loans under the term auction facility. That program was created as an alternative to the Fed's discount window, which is generally used by banks for last-minute funding needs but can carry a stigma because an institution fears being seen as troubled. The $25 billion auctions for 84-day loans will start Aug. 11 and alternate biweekly with $75 billion in 28-day loans. The total credit available under that program will be $150 billion.

The central bank also said it would increase the size of a swap line with the European Central Bank to $55 billion from $50 billion to accommodate a temporary increase in the amount of U.S. dollars the ECB can auction. The ECB and Swiss National Bank are extending 84-day loans in addition to 28-day funds. The Swiss central bank's swap line remains at $12 billion.

Demand for the dollar funding has been rising at each auction since May. In the most recent auction Tuesday, 63 banks bid more than $101 billion for the $25 billion auction. That was the highest number of institutions to bid, and the highest ratio of demand to the amount of funds available, since the ECB opened its swap line with the Fed in December.

Most Fed officials support the efforts to improve market functioning. But their views on the financial situation vary. On one end, officials view the latest market stresses as a source of concern but one that shouldn't stand in the way of raising rates to reverse the aggressive easing -- from 5.25% last September. Officials on the other end believe conditions have worsened dramatically in the past month -- as seen through higher mortgage costs, shrunken bank balance sheets and wider credit spreads -- and add risks to the economy.

While the second quarter delivered strong growth, activity may slow once the effect of economic-stimulus payments fades. High energy prices, a weakening labor market and continued troubles in the housing sector could join tightening credit conditions as restraints to growth into the end of the year.

At the same time, officials are bracing for high inflation readings. Oil this month has pulled off its record high by roughly $20, and gasoline has dropped back under $4 a gallon. Both developments could support a moderating inflation rate in the coming months. But prices remain volatile, and officials are putting little faith in the pullback.

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