Fed steps in but stocks dive; UK to rescue banks

NEW YORK/WASHINGTON (Reuters) - The U.S. Federal Reserve stepped forward as a commercial lender of last resort and signaled a readiness to cut interest rates as stocks spun lower for a fifth straight day and pressure mounted for a coordinated, international response to the worst financial crisis since the Great Depression.

Financial shares tumbled, led by Bank of America Corp, a day after the largest U.S. bank said it would sell $10 billion in new stock and stoked fears that other banks may also need to raise capital.

The British government was readying a rescue package for the UK banking system likely to include public money injected into the banks. That plan will be announced on Wednesday, just five days after the U.S. government approved a $700 billion bailout fund that has failed to calm markets.

U.S. Federal Reserve Chairman Ben Bernanke said the U.S. economy was being battered by a financial crisis of “historic dimension” and that the risk for inflation has eased with the falling prices for oil and other commodities.

“In light of these developments, the Federal Reserve will need to consider whether the current stance of policy remains appropriate,” said Bernanke, who is regarded as an expert on the Great Depression.

In an unprecedented move, the Fed also created a new commercial paper facility that would buy short-term, highly rated debt, stepping into the corporate debt market in a program that falls outside the $700 billion rescue plan approved by the U.S. Congress on Friday.

Stocks remained under pressure while U.S. government bond prices recovered and gold prices moved higher in a continued flight to safety.

The S&P 500 index shed another 6 percent. That broad measure of the market has now dropped 15 percent over five days, its weakest run since 1987.

Earlier, Russia negotiated an emergency bailout for Iceland and unveiled an aid package for its own banks, Australia slashed interest rates by 1 percentage point to 6 percent, and Britain considered a massive injection of public funds.

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Iceland, the North Atlantic island facing down a threat of “national bankruptcy,” took over its second-largest bank and propped up a battered currency.

At ground zero in the crisis, the interbank lending market remained stalled, with the cost of borrowing dollars, euros and sterling all higher as financial institutions sought to preserve capital and remained unwilling to lend to each other.


Analysts credited the Fed with trying to create a fire break in the still-developing crisis, but said it was not enough to stop a wealth-destroying cycle in the markets.

U.S. consumer borrowing dropped for the first time in a decade in August as banks began to tighten credit standards and consumers pulled back from spending.

“I think the Fed has done a reasonably good job considering the unusual situation we are in,” said Joseph Trevisani, chief market analyst with FX Solutions.

Fed fund futures have priced in a 50-basis point rate cut by the Fed this month, with a 75 basis point cut an outside possibility. Expectations have built that the weekend meeting of Group of Seven officials in Washington could set the stage for coordinated rate cuts including the European Central Bank.

U.S. President George W. Bush, whose credibility with voters on economic policy has plunged, said he had spoken with European leaders to make sure there was coordination in dealing with the market turmoil.

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“I have been in close contact with European leaders. I was on the phone with them this morning to ensure that our actions are closely coordinated,” Bush said.

The White House had earlier said Bush spoke with British Prime Minister Gordon Brown, French President Nicolas Sarkozy and Italian Prime Minister Silvio Berlusconi.

In Tokyo, Japanese government officials and media said France had proposed an emergency summit meeting of the leaders of the richest economies and Russia.

The crisis that began with defaults in the $11 trillion U.S. mortgage market is also washing up on Asian shores, pushing South Korea to call for emergency talks with Tokyo and Beijing, and forcing a policy easing from India.

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The International Monetary Fund increased its estimate of global losses from the financial meltdown to $1.4 trillion and warned that the economic downturn was deepening.

“The financial planet is in total crisis,” European Central Bank Governing Council member Guy Quaden said.


Entering a U.S. corporate earnings reporting season, companies were expected to reinforce the view that the world’s largest economy shuddered into recession at the start of the current quarter.

The largest U.S. aluminum producer, Alcoa Inc, posted a drop in quarterly earnings of more than 50 percent on crumbling demand for metal to make planes and cars, and said it would halt major investments. The result was worse than expected and underscored the growing risk of a deepening downturn. Alcoa shares dropped 4 percent in after-hours trade.

“The sad thing here is that I don’t think Alcoa is going to be alone this earnings season,” said Brian Hicks, co-manager of the Global Resources Fund at U.S. Global Investors. “I think there will be quite a few earnings misses due to the fact that it looks like conditions have weakened much more than people expected.”

Shares of Bank of America Corp dropped 26 percent after a surprise earnings announcement a day earlier in which the bank halved its dividend and said it would sell at least $10 billion in new stock to raise capital.

A syndicate source said Bank of America had raised its $10 billion by selling 455 million shares at $22 each -- a sale price 7 percent below Tuesday’s close.

Meanwhile, Wells Fargo & Co stands to claim up to 80 percent of Wachovia Corp’s deposits, while Citigroup Inc would get the remainder, a person briefed on the matter told Reuters. The parties have been in intensive talks to hammer out a compromise in a contested deal for Wachovia also triggered by the credit market distress.

Wachovia and Citigroup declined to comment. Wells Fargo was not available for comment.

Reporting by Reuters bureaus around the world; Editing by Brian Moss, Steve Orlofsky, Toni Reinhold, Gary Hill