March 16, 2008

Fed Chief Shifts Path, Inventing Policy in Crisis

By EDMUND L. ANDREWS

WASHINGTON — As chairman of the Federal Reserve, Ben S. Bernanke has long argued that a central bank should base its policies as much as possible on consistent principles rather than seat-of-the-pants judgment.

But now, as the meltdown in credit markets threatens major institutions on Wall Street and a recession appears inevitable, Mr. Bernanke is inventing policy on the fly.

“Modern monetary policy-making puts a lot of weight on rules, but there is no rule book for an economic crisis,” said Douglas W. Elmendorf, a senior fellow at the Brookings Institution and a former Fed economist.

On Friday, the Federal Reserve seemed to toss out the rule book altogether when it assumed the role of white knight, temporarily bailing out Bear Stearns, one of Wall Street’s biggest firms, with a short-term loan to help avoid a collapse that might send other dominoes falling.

That move came just days after the Fed announced a $200 billion lending program for investment banks and a $100 billion credit line for banks and thrifts. In a move that would have been unthinkable until recently, the central bank agreed to accept potentially risky mortgage-backed securities as collateral.

On Tuesday, the central bank is expected to reduce short-term interest rates for the sixth time since September. The Fed has already lowered its benchmark federal funds rate to 3 percent from 5.25 percent, and investors are betting that it will cut the rate to just 2.25 percent on Tuesday.

The mounting crisis has forced Mr. Bernanke, a former professor of economics, to discard the sanguine view of the nation’s economic health that he expressed last summer. He has also abandoned his skepticism about the need to calm financial markets and set aside his concerns about the “moral hazard” of bailing out big financial institutions.

In Washington and in New York, Fed officials were expected to work through the weekend, analyzing the books of Bear Stearns and trying to prevent its troubles from setting off a chain reaction of failures among its lenders and trading partners.

It was just 10 months ago that Mr. Bernanke, in discussing his reluctance to regulate the booming market for arcane credit instruments, declared: “Central banks and other regulators should resist the temptation to devise ad hoc rules for each new type of financial instrument or financial institution.”

Until recently, Wall Street executives grumbled privately that Mr. Bernanke was too disengaged from the real world, too slow to understand the plight caused by bad mortgages and too hesitant about lowering interest rates.

But Mr. Bernanke has become Wall Street’s most important and most powerful friend. Many executives are praising him for his creativity and willingness to act boldly.

Beyond trying to lower borrowing costs by reducing the federal funds rate, which banks charge one another for overnight loans, the Fed has adopted a widening array of unconventional tools to infuse money into the banking system.

The question now is whether the Fed is already too late, and whether it has enough power to stabilize the markets without starting a new round of inflation. With oil and gold prices soaring to new highs and the dollar falling to new lows, investors already appear to be worrying about higher inflation.

Officially, the Fed continues to predict that the United States can narrowly escape a recession. But Mr. Bernanke has made it clear that the economy is in perilous shape, plagued by a continuing plunge in the housing market, rising job losses, rising energy prices and a paralysis in credit markets as banks and financial institutions sell off even high-quality mortgage-related securities at fire-sale prices.

Most private forecasters contend that a recession is already under way, and even the dwindling numbers of optimists warn that growth will be almost stagnant for the first half of this year.

“The self-feeding downturn now in place shows signs of becoming deeply entrenched,” economists at Citigroup wrote Friday, predicting that the Fed would cut its benchmark rate a full percentage point on Tuesday to 2 percent. Citigroup itself has booked huge losses from its holdings of mortgage-backed securities, and it could face additional losses if Bear Stearns were to fail.

The evolution of Ben Bernanke, who took office in February 2006, began in early August, as credit markets were beginning to freeze up in panic over losses from subprime mortgages. The Fed stunned investors by refusing to lower interest rates and even refusing to change its view that rising inflation posed a bigger risk than slowing growth.

The Fed’s rigidity aggravated fears, and investors were suddenly reluctant to finance a variety of short-term commercial debt, known as asset-backed commercial paper. It is used to finance mortgages, credit card debt, car loans and business loans.

With stock markets plunging and credit availability disappearing, the Fed, along with European central banks, began injecting billions of dollars into financial markets through open-market operations — the buying and selling of Treasury securities.

On Aug. 17, 10 days after the Fed refused to lower its key rate, it held an unscheduled meeting and announced that it would cut the rate at which banks could take out short-term loans from its “discount window,” a program normally used by banks in trouble, and said banks would be able to pledge mortgages as collateral.

It was the Fed’s first step in what quickly became a major course reversal. It signaled that it would probably lower its most important interest rate, the federal funds rate, but it also took its first step toward addressing a cash shortage by lending cash or Treasury securities, backed up by packages of mortgages.

Fed officials say they have not changed their basic principles. Rather, they say, they have changed their view of the economy’s prospects. Throughout last spring and summer, Mr. Bernanke hoped that the economy’s problems would be limited to the housing market and that the financial sector’s problems would be confined to subprime loans.

But by late August, Mr. Bernanke had immersed himself in the structural plumbing of financial markets, from inscrutable mortgage securities like “collateralized debt obligations” to the proliferation of “structured investment vehicles” that permitted investors to borrow at short-term rates to buy long-term debt securities like mortgages.

Mr. Bernanke, working closely with a group of other prominent officials, including Timothy F. Geithner, president of the Federal Reserve Bank of New York, began looking for new tools, beyond interest rates, that the Fed could use to provide relief.

Still, Fed officials found themselves repeatedly startled by the persistence of stress in the credit markets. After the Fed lowered its key rate in September and October, the panic appeared to subside as investors lowered the risk premiums they were demanding on debt securities.

But the panic returned in December and again in January as banks reported a fresh round of multibillion-dollar losses from mortgage-backed securities. Merrill Lynch and Citigroup raised $19 billion in December from Singapore, Kuwait and other countries, but the infusions essentially offset the companies’ latest write-offs and did little to reassure investors.

When Fed officials met Dec. 11 and lowered their key rate another quarter-point, the stock market plunged amid widespread disappointment that the central bank had not done more.

Fed officials hastily telegraphed that they were planning other measures and the next morning announced a new lending program called the “Term Auction Facility.”

The program was open to any bank or depository institution, which would be allowed to bid for up to $20 billion in one-month loans. The twist was that banks could pledge mortgage-backed securities as collateral — including securities that could not be traded and had no market price.

Fed officials expanded the program to $60 billion a month in January and $100 billion a month in March.

Mr. Bernanke did not stop there. On March 7, the Fed said it would infuse an extra $100 billion into the financial system through its open-market operations. And on Tuesday, it created an additional $200 billion lending program that would let some big investment banks borrow money and post mortgage-backed securities as collateral.

“They have been very creative in what they’ve been doing,” said Richard Berner, chief economist at Morgan Stanley.

Others on Wall Street voice frustration over what they see as the Fed’s incremental moves. In a research note on Friday, Merrill Lynch’s chief economist, David Rosenberg, wrote that the Fed’s new lending program “does not address underlying credit problems, does not materially improve the solvency of the institutions exposed to assets under stress, and does nothing to put a floor under home prices.”

By Friday morning, it became clear that more tools would be necessary. Bear Stearns, which had been one of the most aggressive financiers of subprime mortgages, was on the brink of collapse largely because of the sinking value of its own assets.

Hoping to avoid the collapse of a major trading firm that might set off a chain reaction at other firms, the Fed helped work out a deal under which Bear Stearns would borrow money long enough to keep from defaulting on its obligations and either be restructured or sold to its rivals.

The bailout had officially begun.

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