Major banks move to restore confidence

Howard Schneider, Neil Irwin and David Cho
The Washington Post  —  9/18/2008 8:27 am

A consortium of the world's major central banks Thursday morning pumped $180 billion into global financial markets, an effort to ensure banks have access to enough cash and to jump-start a system that had virtually ground to a halt.

The coordinated action, announced at 2 a.m. Central Time, saw the U.S. Federal Reserve provide additional dollars to financial centers around the world, including $110 billion for European banks, $60 billion for the Bank of Japan and $10 billion for the Bank of Canada. The move more than doubles the "swap line" -- essentially a short-term exchange of currencies -- available to the European Central Bank and the Swiss National Bank, and provides new lines to central banks in England, Canada and Japan.

Those institutions, in turn, will make the money available through short-term loans to banks and financial firms that have, given the turmoil of recent days, become hesitant to lend to each other. Short-term loans among financial institutions are critical to the world financial system, but in the current environment banks have hoarded cash and demanded far higher than usual interest rates for that sort of lending.

An early morning news release, distributed simultaneously by the Fed, the Bank of England, the European Central Bank, the Bank of Japan, the Swiss National Bank and the Bank of Canada, said the move is "designed to address the continued elevated pressures in U.S. dollar short-term funding. These measures, together with other actions taken in the last few days by individual central banks, are designed to improve the liquidity conditions in global financial markets."

"The central banks continue to work together closely and will take appropriate steps to address the ongoing pressures."

The swap lines will be available through the end of January, and action Thursday by the European Central Bank showed the level of pending demand for dollars: The bank offered $40 billion in one-day loans and received requests for more than $101 billion.

The joint action by the central banks is not unprecedented. Similar steps were taken earlier this year when a crisis of confidence among financial institutions also disrupted short-term lending. And in the last few days, the Fed, the Bank of England, the European Central Bank and others on their own have injected tens of billions of dollars worth of their own currencies into local markets.

But the situation is appreciably more critical now, with access to cash potentially meaning the difference between failure and survival for major financial institutions. The point was emphasized by the near-failure earlier this week of American International Group -- rescued by an unprecedented $85 billion loan from the Fed -- and in the decision of investment bank Merrill Lynch to sell itself to Bank of America.

The central bank action buoyed global markets -- Asian exchanges erased steep losses after it was announced, European indexes were more than 1 percent higher at midday, and U.S. futures indicated a positive opening on Wall Street after steep losses this week.

But developments around the world spoke to an ongoing sense of upheaval.

U.K. bank Lloyds TSB announced a $22 billion takeover of mortgage lender HBOS -- a deal encouraged by a U.K. government worried about the failure of a major firm. The merger, creating the country's largest mortgage lender, will require the country to relax its antitrust rules.

Central banks in Australia, India, the Philippines, South Korea and elsewhere took steps to steady their own markets, and Russian president Dmitry Medvedev said the government would commit $20 billion to support the country's plummeting stock market, which remained partly shuttered.

President Bush canceled scheduled trips to Alabama and Florida because of "the serious challenges confronting our financial markets" and instead "will remain in Washington to continue to work with his economic advisers," the White House announced late Wednesday night.

"We are still in turmoil. Nobody knows what will happen next. We are all like birds startled at the sound of arrows," said Francis Lun, general manager of Fulbright Securities Ltd., in Shanghai.

The central bank action comes a day after the flow of money through critical parts of the financial system had all but stopped, prompting the stock market to plunge again as banks lost faith in one another and investors rushed to U.S. government securities to protect their savings.

Goldman Sachs and Morgan Stanley, the only major investment banks still standing amid the wreckage of Wall Street's old order, tottered.

In one of the most tumultuous days ever for financial markets, the Dow Jones industrial average fell 449 points, or 4 percent, and so much money fled into safe U.S. debt that buyers were at one point willing to accept interest rates for Treasury bills of only 0.2 percent, the lowest since World War II.

The financial toll continued to mount despite a series of escalating steps taken by the government in recent weeks. As one investment bank failed Sunday and another was taken over, the Federal Reserve loosened its lending to troubled institutions. Then, in its most dramatic step yet, the government on Tuesday took over the enormous insurance company American International Group and extended it an $85 billion emergency loan. None of these measures succeeded in stopping the accelerating troubles.

Investors "are worried there is a lot more out there," said Robert MacIntosh, chief economist for Eaton Vance Management in Boston. "What other firms are going to collapse?"

The seizure in the credit markets made it difficult for the corporate giants of American industry to raise money through the short-term debt they use to make their payroll and extend credit to customers. Ordinary Americans by the millions invest in that short-term debt, called commercial paper, through money-market mutual fund accounts.

On Wednesday, those money-market mutual funds were trying to unload commercial paper on fears of further problems, making it hard for all but the best-rated companies to borrow the money they need. That, in turn, led banks to hoard cash, which sharply raised borrowing costs for ordinary Americans. At one point, the rate that banks charge each other for overnight loans reached 6.4 percent, about triple what it would be in normal times.

The panic in credit markets made for tough sledding for the two remaining independent investment banks, which fund themselves with short-term borrowing. Both companies' stocks experienced their steepest single-day drop ever: Goldman Sachs down 14 percent and Morgan Stanley down 24 percent.

Morgan Stanley's chief executive, John J. Mack, told employees Wednesday that "there is no rational basis for the movements in our stock" and that "we're in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down," according to a staff memo.

Government leaders scrambled to consider their options, with officials at the Treasury Department and Federal Reserve calling contacts in financial markets and counterparts around the world to weigh any further intervention. As of Wednesday night, neither agency had any public comment on the distress.

The Securities and Exchange Commission instituted new rules to combat the "naked short selling" of stocks, a way of betting on their declines without having borrowed actual shares first. The ban could make it harder for hedge funds to make big bets against the shares of troubled companies. Last night, SEC Chairman Christopher Cox announced that he was asking the commission to urgently consider new rules requiring hedge funds and other large investors to disclose their short positions.

The Treasury, in the meantime, auctioned $40 billion in new debt to put the Fed in a stronger position to make future emergency loans, like those extended in the AIG takeover and the rescue of the failing investment bank Bear Stearns in March. The Treasury also established a procedure allowing it to auction off more debt if the Fed requires.

"They're recognizing that they may need more capacity in the days ahead, or at least they want to have that capability to intervene further," said Peter Hooper, chief economist at Deutsche Bank Securities and a former Fed economist.

Throughout the past year, the Fed has been creative at using its authority and nearly $900 billion balance sheet to try to ease the impact of the crisis. The Fed, for example, can lend money to any individual, partnership or corporation under unusual and exigent circumstances. And even after a series of unconventional loans in recent months, the Fed still had $479 billion of Treasury securities it could tap for such actions in the future. But what further options the Fed has remains unclear.

Even as they tightened their lending, banks were evaluating what the future may hold and looking for pairings. At Washington Mutual, a major shareholder waived a clause that made it difficult for the troubled Seattle-based thrift to sell itself, opening the way for a buyer. And Wall Street was rife with rumors that other banks may find merger partners in the coming days.

The turbulence was widespread through U.S. and global markets. Crisis deepened in Russia, where the government halted trading in stocks for the second straight day because of steep declines. There, the global financial crisis is compounded by a reliance on petroleum wealth, which is threatened by the severe drop in the price of oil over the past few months. Asian financial markets tumbled in early trading today, with Japan's benchmark Nikkei 225 index down more than 3 percent and Hong Kong's Hang Seng index off more than 7 percent.

Oil prices did rise yesterday, however, by $6 a barrel, as investors looked for places other than the debt markets to place their money.

Even nations without the severe problems of Russia have been hit: Stocks fell Wednesday in almost every country with an exchange.

There were also discouraging signs for U.S. housing, whose ailing health initially set off the credit crisis and continues to bedevil the financial markets. Home construction starts fell 6.5 percent in August, to 895,000 units, the slowest building pace since January 1991, according to Commerce Department data. It was down 33.1 percent from August 2007.

"We're dealing with a level of construction we haven't seen in two decades," said Mike Larson, a housing analyst with Weiss Research in Jupiter, Fla.

But some of the most severe -- and surprising -- damage to the financial system involved money-market funds, one of the most widely held types of investment in America and a key component in the way corporations and investment banks finance their businesses. Managers of those funds, which control $3.6 trillion, fled for safe havens yesterday, which aggravated a vicious cycle in the credit markets.

Many of these funds, long seen as one of the safest places for ordinary investors and businesses to park their money, have decided to play it safe and put their holdings into Treasury bonds, which are fully backed by the U.S. government. Several funds have even incurred losses, though in most cases they have stepped forward to cover them.

Howard Schneider, Neil Irwin and David Cho
The Washington Post  —  9/18/2008 8:27 am