The Fed Bails Out Money Markets

The Fed, in its collectivistic fashion, bails out the receding money market industry, costing taxpayers $180 billion.

As F.A. Hayek once noted, one intervention leads to another intervention. When will we ever learn from this mess?

September 19, 2008
Fed Offers $180 Billion for Ailing Money Markets
By MATTHEW SALTMARSH and KEITH BRADSHER
Reflecting concerns about the health of the global financial system, the Federal Reserve and the world’s other major central banks significantly escalated their assistance to global markets on Thursday, making almost $200 billion available after bank lending came to a near halt and threatened the global economy.

In a statement released at 3 a.m. in Washington, just as the markets opened in Europe, the Fed said that it had authorized a $180 billion expansion of its temporary reciprocal currency arrangements, known as swap lines, to allow banks to borrow more dollars in money markets at a lower rates.

Paul Mortimer-Lee, head of market economics in the London office at BNP Paribas, said the move reflected concerns that the financial markets now appeared to be facing their gravest problems since the Depression.

“We’re high on a mountain, with a thin rope and holding on by our fingertips,” he said. “Are policy makers scared? They should be.”

The concerted central bank action follows the rout on financial markets this week as the bank Lehman Brothers filed for bankruptcy protection, the brokerage firm Merrill Lynch lost its independence and Washington announced an $85 billion bailout of the American International Group, the insurance giant.

The move seemed to cheer equity investors, who reversed part of the earlier deep slide in Asian markets and bid stocks up in Europe. American stock indexes opened with strong gains, with the Dow Jones industrials rising more than 100 points in early trading.

The central problem is that, lacking confidence in one another’s ability to repay, banks have slowed their lending to each other via the money markets. The short-term rates at which they borrow have surged as they seek to keep cash on their books.

Besides the Fed, the coordinated action involved the European Central Bank, the Bank of Japan and central banks in Canada, Switzerland and Britain.

Analysts are starting to talk about the need for much more intervention from Washington, warning that Thursday’s move would not provide a quick fix to unlock bank lending.

Writing in The Financial Times on Thursday, Kenneth S. Rogoff, the former chief economist at the International Monetary Fund, said the United States would have to spend 5 to 10 times as much as it already has on bailouts, an amount closer to $1 trillion to $2 trillion.

The monetary fund had estimated in April that the losses related to the crisis, which started in mortgage markets in the United States, would be $1 trillion.

Such a rescue would dwarf the huge bailout of the American financial system in the 1980s by the Resolution Trust Corporation, a government-owned, asset-management company charged with liquidating assets of thrifts and the Japanese government’s mass purchase of bad debts from banks during the 1990s.

“We are moving from a monetary solution to a fiscal solution,” said Richard McGuire, a fixed-income strategist at RBC Capital Markets in London. He said that while the central banks’ moves had helped, other efforts would be needed.

Traders usually look at spreads in the money markets to measure the health of the money markets and judge whether banks are willing to lend to one another — and ultimately to consumers. Spreads are the differences between interest rate charges overnight and those charged over a longer period.

After the fund injections by the banks, the cost of borrowing dollars overnight fell, with the benchmark Libor rate falling 1.19 percentage points, to 3.84 percent, Bloomberg News reported, citing the British Bankers’ Association.

But the gap between three-month United States Treasury yields and the three-month London interbank, or Libor, rate — known in the market as the TED Spread — narrowed only slightly, to around 299 basis points at midday in London, from just over 300 basis points Thursday. A similar slight narrowing of spreads was seen in sterling and euro markets.

“The dust may settle and the market may take a more sanguine view in time,” Mr. McGuire said, “but for now, it looks like a palliative rather than a panacea.”

In its statement Thursday, the Fed said that as part of the infusion, it had also authorized increases in the existing swap lines with the European Central Bank, up to $110 billion, from $55 billion, and the Swiss National Bank, up to $27 billion, from $15 billion. Similar arrangements were announced with the Bank of England and the Bank of Canada.

“The central banks continue to work together closely and will take appropriate steps to address the ongoing pressures,” the European Central Bank said in a statement.

Smaller central banks were also active on Thursday in providing extra money to their country’s financial systems so as to make sure that banks and other financial institutions could find money to borrow without having to pay exorbitant interest rates.

The Hong Kong Monetary Authority, for example, injected 1.556 billion Hong Kong dollars, worth $200 million, into the territory’s banking system on Thursday afternoon, John Tsang, the financial secretary of Hong Kong, said.

The monetary authority acted after the interest rate that Hong Kong banks pay to borrow money overnight from one another suddenly tripled shortly after lunchtime, to 4 percent, and threatened to rise further.

The maneuver appeared to be successful, with overnight interest rates falling through the rest of the afternoon. Central banks in Japan, Australia and India pumped tens of billions more into money markets, while China’s central bank said it had lowered the rate at which it conducts bond repurchase agreements.

Analysts said the central banks were doing what they could.

“This is clearly a very significant help and central banks are showing decisive leadership here as risk aversion is hitting the private sector,” said Julian Callow, chief European economist at Barclays Capital in London.

Still, noting that the Fed left its benchmark short-term rate unchanged this week, analysts said that the cash infusions did not necessarily mean that central banks would lower their benchmark short-term interest rates.

“If anything,” Mr. Callow said. “this sends the signal that they are trying to achieve stability via money markets rather than by cutting short-term rates.”

Heather Timmons contributed reporting.