Dramatic Fed Move to Unlock Markets

By Ambrose Evans-Pritchard
The Telegraph, London
Wednesday, March 13, 2008


The US Federal Reserve has taken the boldest action since the 1930s, accepting $200 billion (L100 billion) of housing debt as collateral to prevent an implosion of the mortgage finance industry and head off a full-blown economic crisis.

The Bank of England, the key European central banks, and the Bank of Canada all joined in a co-ordinated move with a mix of policies to halt the downward spiral in the credit markets, expanding on the "shock and awe" tactics used late last year.

The Fed's dramatic step came after an emergency conference call by governors on Monday night.

It followed the meltdown of the US chartered agencies -- Fannie Mae, Freddie Mac, and other lenders -- which together guarantee 60 percent of the entire US home loan market.

Fannie Mae's share price fell 19 percent on Monday after Barron's magazine said it may need a rescue package.

"The agency crisis was a tsunami event," said Tim Bond, global strategist at Barclays Capital. "The market was starting to question the solvency of bodies that stand at the top of the credit pile. These agencies together wrap or insure $6 trillion of mortgages. They cannot be allowed to fail because it would cause a financial disaster. That this sector has blown up has caught everybody's attention in Washington."

The Fed action set off a powerful relief rally, lifting the Dow Jones index more than 350 points in late trading. Both US and European equities have been hovering on key support lines in recent days, threatening to break down through 18-month lows in a second leg to the bear market.

Stress indicators across almost all parts of the global credit system fell from extreme levels on the Fed news.

The CDX and iTraxx Europe indexes that serve as a default barometer for corporate bonds retreated from record highs, although it is too early to judge whether the latest action will start to thaw the credit freeze. The stock market rally after the last central bank intervention in December fizzled out after just one day.

"This is not going to be enough," said Hans Redeker, currency chief at BNP Paribas. "The Fed is doing the right thing by soaking up mortgage debt nobody else wants. This will have an impact on spreads, but we're seeing the deflation of a major bubble. The Fed is still going to have to cut rates by 75 basis points next week."

It is a groundbreaking move for the Fed to accept mortgage collateral, even if the debt is theoretically "AAA-grade" debt.

The Fed is not allowed to buy mortgage bonds outright, but it can achieve a similar effect by letting banks roll over collateral indefinitely.

The European Central Bank is already doing this, shielding Dutch, Spanish, German, and some British banks from the full impact of the credit crunch.

The Fed is to create a facility that allows banks to swap mortgage bonds for US Treasuries. It is a well-targeted move to avoid adding fuel to inflationary fire. It follows the Fed's separate pledge last Friday to add up to $200 billion in liquidity.

The Bank of England also said it was widening the range of eligible collateral as it offers L10 billion of three-month loans, saying pressures in the money markets "have recently increased again."

The ECB and the Swiss have boosted swap agreements with the Fed to provide $30 billion and $6 billion respectively in dollar liquidity to their own lenders.

Bernard Connolly, global strategist at Banque AIG, said the Fed action may help calm the markets for now, but it cannot solve the root problem of eroded bank capital.

He said: "There is the risk of a very damaging credit contraction. We face the most serious global crisis since the Great Depression. But at least the North American central banks are doing their best to stop it spreading to the real economy."

The emergency actions appear to have been co-ordinated by the Fed's top two figures, Ben Bernanke and Donald Kohn, working with the Bank of Canada's Mark Carney.

"We should be thankful we have people in charge who appreciate the gravity of the situation," said Mr Connolly.

The travails at Fannie Mae and Freddie Mac had combined in a deadly cocktail with a fresh wave of panic over the solvency of the investment banks with heavy exposure to sub-prime debt. Mr Bond said the mortgage agencies may need to be nationalised. Fannie Mae's shares have fallen 70 percent since October, even though it has an implicit federal guarantee.

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