Fed, counterparts coordinate to ease market stress

WASHINGTON Wed Dec 12, 2007 4:59pm EST

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WASHINGTON (Reuters) - The U.S. Federal Reserve on Wednesday launched a new temporary short-term lending facility to ease credit market strains in concert with market-calming actions by several other major central banks.

The Fed, the U.S. central bank, said it would launch a "temporary term auction facility" that banks can use to secure funds and avoid borrowing through its traditional discount window.

The move is aimed at easing money market strains that intensified in November and may intensify with banks' normal year-end demand for cash.

"This is not about particular financial institutions with particular problems. It is about market functioning," a senior Fed official told reporters on a conference call.

The official said there should be no stigma associated with borrowing via the new weekly and bi-weekly term auctions, as banks can obtain funds through an anonymous bidding process.

The Fed has committed to two auctions of $20 billion each in December and two other auctions of an undetermined size in January, and will study whether to make the arrangement permanent.

The European Central Bank and counterparts in Canada, Britain and Switzerland announced similar moves, along with some facilities for foreign exchange swaps.

The announcement comes a day after the Fed trimmed benchmark interbank interest rates by a modest quarter percentage point to 4.25 percent and cut the discount rate it charges banks for loans by the same amount, to 4.75 percent.

That disappointed investors and stock markets tumbled sharply, but within minutes of the U.S. stock market's open on Wednesday a large part of those losses had been erased as investors saw the Fed action as likely to help settle markets.

U.S. stock markets by lunchtime had fallen back to being up less than 1 percent from Tuesday's close.

"This is exactly what the market was praying for yesterday to address legitimate fears about a year-end credit crunch," said Chris Rupkey, vice president of the Bank of Tokyo/Mitsubishi in New York. "The coordinated effort with other central banks is probably the most important aspect of this as this crisis is certainly on a global scale."

The dollar hit a one-month high against the yen but slipped against the euro and sterling. U.S. Treasury debt prices tumbled as investors poured money back into stocks.

DISCOUNT WINDOW DISAPPOINTMENT

When credit market strains first appeared in August as the U.S. housing market soured, the Fed announced an emergency cut to the discount rate governing direct loans to banks to boost liquidity. While there was an initial increase in borrowing at the window, this fell off within weeks.

Analysts say banks are often reluctant to borrow from the "lender of last resort" discount window because it carries a stigma associated with banks experiencing financial problems or poor collateral.

"No institution wants to be seen as potentially having funding issues," said T.J. Marta, fixed income strategist at RBC Capital Markets in New York.

The Fed official said the new auction facility will accept the same collateral as it accepts at the discount window, including potentially illiquid securities such as collateralized default obligations that are given a "haircut" in value.

The Fed said the temporary facility would allow it to inject short-term funds into strained markets through a broader range of counterparties and against a broader range of collateral than through its usual open-market operations.

Normal open-market operations may be reduced depending on demand from the new auction facility, the Fed official said.

With banks highly reluctant to lend to each other in the money market, the gap between three-month Treasury bill yields and the three-month dollar interbank lending rate had jumped to around 220 basis points from about 50 in late July, before the credit crisis gripped global markets.

There are 100 basis points in a percentage point.

The Fed's Tuesday rate cut followed renewed deterioration in credit markets after major financial institutions around the world reported billions of dollars' worth of write-downs due to extensive exposure to delinquent risky mortgages.

Markets and policy-makers have been caught off guard by how hard and broadly rising defaults on U.S. subprime mortgages have hit. As roughly 1.8 million adjustable-rate mortgages line up to reset at sharply higher interest rates in 2008, the prospect of more pain for U.S. homeowners and banks has increased in recent months.

(Editing by James Dalgleish)

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