Fed's bold $200 billion move

The central bank's unusual cash infusion aims to keep banks lending.

The Federal Reserve is becoming increasingly creative in its efforts to keep the world's credit markets from shutting down.

The central bank's latest effort is to show the world's lenders it has faith in the highest quality debt – whether it's issued by such institutions as Fannie Mae or a highly rated company.

Later this month, the Fed, in concert with other central banks in Europe, will offer to swap up to $200 billion in US Treasury securities for other debt including mortgage securities.

The move, which was met with wide approval on Wall Street, is essential to keep liquidity flowing at a time when some lenders are growing wary even of debt with the implicit guarantee of the US government. Without the Fed's actions, there could have been a further deterioration of the nation's housing market.

"This indicates the Fed is the true lender of last resort," says Doug Roberts, chief investment strategist for Channel Capital Research, based in Shrewsbury, N.J. "It's not bailing people out but it is providing a sandbag."

However, some economists worry that the Fed is going to potentially fund assets other than US Treasury obligations. "Every politician will soon have their pet set of loans they would like to see supported," cautions Bob Eisenbeis, chief monetary economist at Cumberland Advisors and a former director of research at the Federal Reserve Bank of Atlanta.

Fed watchers also warn that the Fed's latest actions will not do much to arrest falling housing prices. Last year for the first time since the Great Depression, home prices fell. They are widely expected to drop again this year since the inventories of unsold homes is quite high by historical standards.

"To a large degree the Fed's actions do not get at the solvency issues," says Paul Kasriel, chief economist at the Northern Trust Company in Chicago. "We're seeing the bursting of the credit bubble, and one of the main assets is homes and they are declining in value, which is putting pressure on mortgage-related debt."

Helping Bear Stearns

However, many Fed observers agree the central bank had to act. Interest rates had risen on loans guaranteed by Fannie Mae, Freddie Mac, and other agencies with debt implicitly guaranteed by the US government. Last week, this resulted in a $400 million margin call on Carlyle Capital, which had a $21.7 billion portfolio of residential mortgage-backed securities, many of them rated AAA, the highest quality.

At the same time, on Monday some analysts became concerned about Bear Stearns, one of the nation's primary dealers in Treasury securities. The investment company's stock was falling and there were reports it was costing more money to fund its borrowing costs. A company executive told CNBC it was not having any liquidity problems.

One of Fed chairman Ben Bernanke's hobbies is studying the causes of the Great Depression. At the start of the Depression, many small banks that had speculated went out of business. Then, larger, more established banks were squeezed.

"There was a whole cascade effect," says Mr. Roberts. "So there is concern if one dealer has a problem, it could cascade to another dealer because once the domino starts to fall it becomes hard to stop."

Move spurs market rally

The Fed's actions have met with wide approval on Wall Street. On Tuesday, after the announcement was made, the Dow Jones Industrial Average leaped 416 points. On Wednesday morning, the market's rally continued with the Dow up another 132 points.

"The market is celebrating the Fed's action here," says Phil Flynn of Alaron Trading in Chicago. "The problem was the market felt the Fed's prior actions were not viewed as big enough or effective enough to make the banks want to lend money."

Mr. Flynn says Wall Street is also relieved the Fed recognizes that it needs to do more than cut interest rates. Since Sept. 17th, the Fed has lowered interest rates by two and a quarter percentage points.

"However, it was having a negative effect, the dollar is down and we're getting commodity inflation that is putting stresses on the economy," says Flynn. "This is another weapon in the Fed's arsenal."

In fact, some economists believe the Fed's latest move will mean the central bank will be under less pressure to lower interest rates sharply when it meets on March 18. Up until yesterday, the credit markets were expecting a three quarters of a point interest rate drop.

"Now, it gives them the chance to make a half point cut instead," says Scott Brown, chief economist at Raymond James & Associates in St. Petersburg, Fla.

A temporary relief

Despite Wall Street's optimism, economists warn banks are likely to continue to be difficult lenders. Mortgage defaults are rising as are foreclosures. "These are genuine losses and the banks will have to write down this debt and see their capital erode," says Mr. Kasriel, who compares the current situation to the early 1990s when the banking system saw some substantial losses.

"It takes time to rebuild capital, to rebuild profits," he says.

However, Roberts says the Fed's move gives the banks some breathing room. "Bernanke's Fed is being innovative in dealing with this."

The Fed's move has helped to change the mood of the markets. "I think it's more of a psychological kind of move," says Mr. Eisenbeis. "It's a step to improving the Fed's credibility, it's showing us they are on top of things."