Dow skyrockets on Fed’s $200 billion pledge

Attempting to break the credit logjam that is threatening the already weakened economy, the Federal Reserve on Tuesday announced a new program to pump massive sums into major banks and brokerages.

The battered stock market, which Monday had fallen to its lowest levels in at least 18 months, responded with its biggest one-day rally in five years. The Dow Jones industrial average rocketed 416.66 points, or 3.6 percent, to 12,156.81.

In a surprise, the Fed said it would begin to temporarily lend financial institutions as much as $200 billion in U.S. Treasury securities it owns in exchange for mortgage-backed securities that in many cases have slumped in value because of market anxiety over soaring home loan defaults.

With rock-solid Treasury bonds in hand, Fed officials hope, banks and brokerages will return to something closer to normal investing and lending practices. That could ease the credit crunch that took hold with the housing market’s plunge last summer but since has spread to many unrelated corners of the banking system and economy.

“They’ve pulled out all the stops to try and fix this problem,” said Christopher Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi in New York.

Behind the huge dollar amounts involved in the Fed’s latest move, experts said, is an urgent need to restore confidence in the financial system before the mood of investors and consumers gets so bad that policymakers can’t turn it around.

“There is a danger of a downward spiral in the economy,” Rupkey said. “They have to address it.”

Many economists believe the country has already entered a recession. The government Friday reported a net loss in February of 63,000 jobs, the most in five years.

When policymakers meet next Tuesday, they are expected to again reduce their benchmark short-term interest rate from the current 3 percent to at least 2.5 percent.

Despite five cuts in its key rate since August, however – and previous announcements of smaller programs to pump money into the financial system – the Fed has been unable to reverse a cycle of tightening credit, falling home prices and tumbling securities markets.

Indeed, senior Fed staff members who spoke to reporters Tuesday on condition they not be further identified said the central bank was frustrated with the lack of progress in bolstering the financial system.

“They’re on Plan B now,” said James Glassman, senior economist at JPMorgan Chase & Co. in New York. “The Fed knows there’s a lot of danger here.”

The new Fed program was approved in a conference call of central bank officials Monday evening, days after a less ambitious lending plan announced Friday.

Earlier Monday, Wall Street had been rocked by rumors that Bear Stearns Cos., one of the country’s largest brokerages, was running short on cash because other financial giants would not lend to it. The company’s shares plunged 11 percent even though the firm said there was “absolutely no truth” to the rumors.

Also Monday, shares of Fannie Mae and Freddie Mac – the two government-sponsored lending giants that are supposed to help lead a housing-market rescue – dived to their lowest levels since 1995 after a weekend story in Barron’s, a financial magazine, questioned whether Fannie Mae itself could become insolvent.

When the mortgage-finance crisis began last summer it was centered in the so-called subprime loan market for mortgages made to people with dicey credit. As delinquency rates on those loans surged the value of bonds backed by the mortgages crumbled, causing massive losses for banks, brokerages and investment firms that owned the bonds.

In recent months, Wall Street’s fears of greater losses on home loan-backed bonds has intensified as the outlook for housing and the economy worsened. Even many bonds backed by the highest-quality mortgages have gone begging for buyers.

That has made major banks more reluctant to lend to each other and to brokerages and investment funds saddled with large portfolios of mortgage-backed securities.

What’s more, the turmoil pushed up mortgage rates for home buyers in February, after a decline that had pulled the average 30-year loan rate below 6 percent in January, to the lowest since 2005.

In effect, the Fed has found itself pouring liquidity into a financial plumbing system with a frozen pump.

Now, by agreeing to exchange Treasury bonds for mortgage bonds in temporary swaps with financial institutions – including brokerages such as Bear Stearns – the central bank is hoping to halt or even reverse the decline in the value of high-quality mortgage securities, analysts said.

“The Fed is trying to say, ‘This isn’t as bad as some of you think and we’re going to put our money where our mouth is,’ ” said Brian Bethune, an economist at Global Insight, an economic forecasting firm in Lexington, Mass.

If policymakers can convince cash-hoarding investors that they shouldn’t wait any longer to snap up high-quality mortgage securities, the result could be an explosion of buying that could feed on itself, analysts said.

Opportunistic investors “never wait for the problem to be solved – they just wait for the lessening of the problem” before moving in, said Joseph Carson, an economist at investment firm AllianceBernstein in New York.

Under the Fed’s plan, the Treasury-bond loans will be for 28-day periods, instead of overnight, the traditional period for such swaps. The program will begin March 27.

Fed staff members stressed that the central bank will take only top-rated mortgage securities as collateral, not risky subprime bonds. Approved bonds include those of Fannie Mae and Freddie Mac.

“It’s a very creative approach. It will go pretty far in addressing the confidence issue” regarding bonds of the two mortgage-finance giants, said Diane Swonk, chief economist at Mesirow Financial in Chicago.

Still, some experts said the Fed’s temporary securities-swap program does not solve the basic problem weighing on the financial system, which is that many lenders and investment firms are saddled with bonds backed by deeply troubled home loans.

Scott Simon, a mortgage-securities expert at Pacific Investment Management Co. in Newport Beach, Calif., a leader in bond mutual funds, said he believed that the Fed ultimately would have to begin buying mortgage-backed bonds outright and hold them in its portfolio to take the burden from the financial system.

The Fed, and the Bush administration, so far have opposed such a move, saying the government should not bail out the mortgage market.