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Fed looks to end credit crunch

Ben Bernanke and the Fed join up with other central banks to help beleaguered financial institutions borrow more easily.

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By Paul R. La Monica, CNNMoney.com editor at large

Reading the Fed

NEW YORK (CNNMoney.com) -- One day after disappointing Wall Street with a quarter-point rate cut, the Federal Reserve announced a plan Wednesday to inject billions of dollars into the financial system.

Investors cheered the news at first. The Dow surged 200 points in early trading. But it wound up being a wild day on Wall Street as fears about rising oil prices and more troubles in the banking sector weighed on stocks. The Dow gave up all its gains later in the day before recovering to finish slightly higher. The S&P and Nasdaq both rose modestly as well.

The central bank plans to hold four special auctions between Dec. 17 and Jan. 28 to allow banks to bid for the right to borrow money directly from the Fed. The first two auctions will be for up to $20 billion each. The amounts of the third and fourth will be determined in January, the Fed said in a statement.

The Fed is giving beleaguered banks the opportunity to access funds without having to borrow money directly from the Fed at the usual short-term discount rate, which stands at 4.75 percent.

"This is very significant. It's a recognition of the turmoil in the financial system," said Mark Zandi, chief economist with Moody's Economy.com, a research firm.

"This should help assuage concerns that the Federal Reserve is a step behind events, and markets should take solace in this," Zandi said. "The Federal Reserve is trying to provide more cash to the banking system."

Some market observers suggested that banks would likely be able to avoid the so-called stigma associated with the discount rate and borrow money through the auction process at a rate closer to the federal funds rate, which is now 4.25 percent.

"There is no reason to believe there would be stigma associated with the use of this facility," said a senior Federal Reserve official, speaking on background. The Fed will not disclose which banks borrowed money through the auction process or what collateral they put up, the official added.

The Fed cut its federal funds rate, which is what banks charge each other for overnight loans, and its discount rate Tuesday. But the Dow plunged nearly 300 points Tuesday and the S&P 500 and Nasdaq slid about 2.5 percent as many investors were hoping for a half-point cut.

The Fed official said that the sell-off on Tuesday did not affect the timing of the auction news.

"Market reaction yesterday had nothing to do with today's announcement. This has been in the works for a while. The market response was not a factor," the Fed official said.

The Fed added that it was coordinating with the Bank of Canada, European Central Bank, Bank of England and Swiss National Bank on the auction process in order to "address elevated pressures in short-term funding markets."

The other central banks will hold auctions similar to the Fed's. The Fed also set up foreign exchange swaps to allow the European Central Bank and Swiss National Bank to make loans in dollars instead of their much stronger currencies. The hope is that this will lead to lower interest rates abroad.

"This was a global effort among a number of central banks. We wanted to announce that together. We couldn't announce that yesterday as Europe was closed," the Fed official said.

"We were finalizing details, both our own and with other central banks. We and the other central banks wanted to make this announcement when the affected markets were open," the official added.

Economists said the auctions could help banks that have been reeling due to their exposure to subprime mortgage loans. Financial institutions such as Citigroup (Charts, Fortune 500), Bank of America (Charts, Fortune 500), Washington Mutual (Charts, Fortune 500), Wachovia (Charts, Fortune 500), Merrill Lynch (Charts, Fortune 500) and UBS (Charts) have all reported large writedowns in the past few weeks.

But the Fed official said the auction process was set up to ease the credit crunch and was not aimed at bailing out any specific lenders or banks.

"This is not about particular financial institutions with particular problems. It is about market functioning," the Fed official said.

So will the Fed's plan help end the credit crunch? Several economists said it certainly won't hurt.

"This is a move in the right direction. The Fed realizes that financial markets are fragile. And that's what today is all about," said Chris Probyn, chief economist with State Street Global Advisors in Boston.

"Banks are not going to the discount window because of stigma associated at borrowing above the fed funds rate. Now the Fed will probably be pushing money out at something around fed funds rate, which won't be penal," Probyn added.

Another economist said the Fed redeemed itself on Wednesday. Many investors seemed to be concerned that the Fed does not share the grim outlook for the economy that Wall Street has. As such, there were fears that the banking crisis could worsen if the Fed did not take more aggressive action.

"This is a major move given the feeble move in interest rates on Tuesday. There was universal disappointment that the Fed didn't go farther," said Kenneth Kim, an economist with Stone & McCarthy Research Associates, a research firm based in Princeton, N.J.

"This must be the Fed's idea of being nimble," Kim added, referring to the word that Fed Vice Chairman Donald Kohn used in a speech in late November to describe the Fed's monetary policy stance.

Zandi of Economy.com said that consumers probably won't see an immediate tangible benefit from the Fed's actions Wednesday. But he said that the auctions are good news for borrowers since it could convince banks they don't have to tighten their lending standards so much as to grind borrowing activity to a halt.

"If your bank is under financial pressure, they are less likely to make a loan to you at an attractive interest rate," Zandi said. "This is an effort to make banks more willing to lend money to consumers."

But Keith Hembre, chief economist with First American Funds in Minneapolis, warned that the Fed's auction plan will not stop the bleeding at big banks.

"This won't stop the parade of writedowns. We can expect a lot more. Everyday, someone is coming out with more and more," said Hembre.

Hembre is predicting that when all is said and done, banks may report a total of $250 billion in losses associated with subprime mortgages. According to various estimates, banks have already reported about $100 billion in writedowns.

What's more, market observers said that the Fed will need to continue lowering interest rates in order to ensure that the economy doesn't slip into a recession.

"This plan is not changing much for the economy. We're still in a slowdown. The Fed will have to ease come January and the months ahead," Stone & McCarthy's Kim said. To that end, he expects the Fed to cut rates by another quarter-point in January and that more quarter-point cuts are likely later in the year.

But State Street's Probyn said it may be a mistake for investors to assume that the Fed will cut rates many more times. He said the fact that the Fed didn't cut rates by a half-point Tuesday and followed that up with the auction plan shows that it clearly thinks the solution to the credit crunch is not through monetary policy.

"We have a Fed that wants to go slowly on rate cuts because their projections are all saying that nothing really bad is going to happen to the economy. Yes, you'll have sluggish growth but you'll have a turnaround at the end of the year and they're not expecting a big pickup in unemployment," he said.

"I'm not convinced rates will go below 4 percent. The Fed may cut again in January but will be open minded and reassess the situation after that. No cuts beyond January are cast in cement," Probyn added. To top of page

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