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Fed to lend $20 billion to banks

Central bank, in a bid to ease credit crunch, gets strong demand for short-term funding. Wall Street shrugs.

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

NEW YORK (CNNMoney.com) -- The Federal Reserve announced Wednesday that it was lending $20 billion to banks in the first of four special auctions designed to help alleviate the credit crunch on Wall Street.

The Fed said that it received requests for $61.6 billion in loans from 93 bidders - illustrating strong demand by banks that need short-term funds. The winning bidders will receive their loans, which will mature in 28 days, on Thursday.

Stocks seesawed throughout the day Wednesday and finished mixed. The Dow and S&P 500 fell while the Nasdaq rose slightly.

Bonds rallied, pushing the yield on the benchmark 10-year U.S. Treasury note down to 4.07 percent. Bond yields and prices move in opposite directions.

One market expert said the auctions will do little to ease the pain in the financial markets.

"This is a crisis of confidence, not of liquidity or rates. The problem is that people made bad loans this year. There's nothing the Fed can do to fix this. All they can do is try and reduce anxiety," said Barry Ritholtz, director of equity research for Fusion IQ, an asset management firm based in New York.

The Fed last week announced the auction plan in conjunction with central banks in Canada and Europe. A senior Fed official said at the time that the central bank was hoping banks that needed funding would be less hesitant to ask for money through the new anonymous auction process than they were to borrow directly from the Fed.

Many banks had been wary of borrowing money at the Fed's so-called discount rate of 4.75 percent because it is higher than the federal funds rate of 4.25 percent. The federal funds rate is what banks charge each other for overnight loans. The Fed lowered both rates last week by a quarter of a percentage point.

In addition, market observers feel that there is a stigma attached with borrowing at the discount rate because it may be a sign that banks are so desperate for short-term cash that they are willing to pay the higher interest rate for the funds.

But the Fed said last week that it expected the loans would be made at a lower rate than the discount rate and this bore out. The Fed said Wednesday that the the lowest rate for the loans was 4.65 percent.

One fund manager said that the auction may help banks somewhat but that the results were not that significant since the rate on the loans is still above the fed funds rate.

"The Fed is trying to do its job. This was a reasonable thing for them to do and it's ultimately good for banks that don't want to go to the discount window. But the rate is at the middle of the road," said Jamie Jackson, a portfolio manager with RiverSource Investments in Minneapolis.

The Fed said last week that the minimum rate offered in the auction would be 4.17 percent and that maximum loan amount to an institution would be $2 billion.

The second of the four auctions will take place on Thursday. The Fed has said it will offer up to $20 billion in this auction. The loans will mature in 35 days and banks will receive the money on Dec. 27.

The results of the Fed auction come a day after the European Central Bank announced it would lend an unlimited amount of money to banks bidding at least 4.2 percent for loans.

Federal Reserve Chairman Ben Bernanke and other central bankers across the globe have been attempting to inject more liquidity into the financial system in order to make sure that banks don't run into even more difficulties resulting from the supbrime mortgage meltdown.

Many large banks in the United States and Europe have been forced to write down billions in assets because of bad bets on mortgage loans. And the concern is that without access to more capital, banks may tighten lending standards.

In turn, this could accelerate a slowdown in the economy and possibly even send the U.S. into a recession if banks are no longer interested in loaning as much money at attractive rates to consumers and businesses.

But Fusion IQ's Ritholtz was skeptical that the new loans would cause banks to loosen their credit standards.

"The problem that the Fed is facing is not an issue of rates being too high and an inadequate amount of liquidity. It's that banks have gone from being willing to lend to a corpse to lending to nobody," said Ritholtz.

Still, the Fed is in a tough spot. It is trying to make sure the woes in the financial services industry don't spill over into the broader economy.

The Fed said last week when it lowered interest rates that "economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending."

But at the same time, the Fed said it remained concerned about rising inflation pressures. That spooked Wall Street, which interpreted the Fed's inflation worries as a sign that the central bank may not lower interest rates as aggressively in 2008 as many had hoped.

These fears intensified later last week after the government reported that wholesale prices and retail prices both rose more than expected in November. And that has sparked fears on Wall Street of "stagflation," a period of rising inflation and slowing growth.

In a speech Wednesday, Federal Reserve Bank of Richmond President Jeffrey Lacker said he was "uncomfortable with the inflation picture" and that the Fed needed to be concerned not just with so-called "core" inflation - which excludes the effect of oil and food prices - but overall inflation.

"If energy prices fail to decline, monetary policy decisions will be that much more difficult in 2008," said Lacker, an avowed "inflation hawk" who voted for a quarter-point rate hike at the last four Fed meetings of 2006.

Lacker, who is not a voting member this year, was the only one to vote for a hike at those meetings, which all concluded with the Fed keeping rates steady.

But he is not alone in fearing inflation. Former Fed chairman Alan Greenspan used the term "stagflation" on an appearance on ABC's "This Week" on Sunday.

With all this in mind, one fund manager said the Fed should tread cautiously.

"The Fed has to maintain price stability and keep the economy moving forward without jeopardizing growth," said Ted Parrish, co-manager of the Henssler Equity fund, which owns shares of big financial firms Goldman Sachs (GS, Fortune 500), Bank of America (BAC, Fortune 500) and AIG (AIG, Fortune 500).

"Yes, the Fed has to give some help to banks," Parrish said. "But they are not here to just to appease and bail out Wall Street."  To top of page

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