Image: Ben Bernanke
Jason Reed  /  Reuters file
Federal Reserve Chairman Ben Bernanke faces his first major financial crisis as the central bank has moved to calm the meltdown in the credit markets.
By John W. Schoen Senior producer
updated 8/10/2007 5:38:20 PM ET 2007-08-10T21:38:20

Just days ago Federal Reserve Chairman Ben Bernanke and his colleagues held their regular August meeting and elected to leave interest rates unchanged, issuing a mild statement that expressed optimism about the economy.

On Friday, as Bernanke faced the first big crisis of his 18-month tenure, the central bank was forced into action, buying up billions of dollars worth of crumbling bonds in an effort to stabilize financial markets that appeared to be coming unglued.

For now, the Fed's medicine appears to be working. Stock prices fluctuated wildly Friday, but the Dow Jones industrial average, which was off more than 200 points early in the session, was off a bit over 30 points at the close. The Dow and other broad indicators actually advanced for the week, despite Thursday's frightening 387-point drop.

But as central banks around the world poured some $325 billion into global markets some observers are asking: Did the Fed move too slowly to calm the waters?

Credit problems have spread rapidly this week, rendering moot the Fed’s previous assessments that turmoil was mainly contained to the market for "subprime" mortgage loans made to borrowers with weak credit.

One of the major sparks that touched off the latest fire was the announcement by Paribas, a large French bank, that it was no longer allowing investors to withdraw money they had invested in three funds backed by subprime mortgage loans. Paribas said it was no longer able to determine how much the securities in the funds were worth.

The problem Paribas faces is shared by dozens of hedge funds and investment banks that are holding mortgage-backed bonds. The outlook for mortgage delinquencies and defaults is still extremely clouded, and computer models used to assign values to the bonds backed by these mortgages have broken down. So too, has the market for the bonds: Few are interested in buying them at any price.

In response, central bankers around the world began pouring money into the system Thursday to avert a wider panic that could spook investors into cashing out securities in a classic run on the bank. Led by the European Central Bank and the Bank of Japan, central banks in Australia, Malaysia, Indonesia, Taiwan and the Philippines injected billions of dollars of cash into credit markets by buying up bonds — moving cash into the accounts of dealers that held them.

The Federal Reserve followed suit on Friday spending some $36 billion to buy up bonds that no one else would touch. The move is temporary — the paper has to be repurchased by sellers within three days. But the hope is that by halting the panic, the Fed will give investors time to catch their breath and perhaps find a measure of stability when markets reopen Monday.

“The Fed has driven a stake in the sand and I'd be real surprised if they backed away from it at this point,” said Gregory Miller, chief economist at SunTrust Banks. “They're injecting relatively small amounts of liquidity and … they can continue to monitor that from day to day very closely and add sort of surgically any time it looks like that we need only overnight relief.”

Adding to the uncertainty is the presence of a Bernanke who stepped up last year to succeed Alan Greenspan, who was tested repeatedly by crises in his 18 years as Fed chairman. The Fed's surprise action Friday gave market players increased  confidence that Bernanke will try to help financial markets in times of trouble, as did his predecessor Alan Greenspan.

Major Market Indices

“He's not telegraphing any rules,” said Joseph Mason, finance professor at Drexel University.  “Greenspan made very clear what the rule was: Markets get into trouble, we're going to bail you out. Bernanke's not being clear about that rule, and I think that goes back to Bernanke's experience and understanding of financial crises over his academic career and his in-depth study of financial crises as well.”

Some investors believe that the Fed erred by not taking the broader step of cutting interest rates this week — and that it will be forced to cut rates soon. Investors in the futures market are already betting that a cut of up to a half-percentage point is all but certain, perhaps even before the Fed's next scheduled meeting Sept. 18.

But other Fed watchers believe that, as long as the economy remains strong, cutting rates could simply bring a return to the easy-money lending the created the credit bubble and led to the current bust.

“This (injection of money by the Fed) will not yet signal a change in monetary policy or administered rates; we expect the Fed funds rate to remain unchanged,” said Global Insight economists Brian Bethune, Nariman Behravesh and Nigel Gault in a note. “A deeper or persistent credit crunch might lead to a rate cut, but the first mission of the Fed is to maintain market liquidity.”

And as the Fed repeated in its official policy statement Tuesday, the credit crunch — so far —has not created serious problems for the broader economy. On the contrary, according to the Fed view, economic growth is still strong enough that inflation remains its primary concern.

That view is shared by a number of private economists.

“While Wall Street is clearly feeling some pain, Main Street is holding up reasonably well,” said Wachovia Securities chief economist John Silvia in a note to clients Friday.

One of the biggest problems confronting holders of thinly traded mortgage-backed bonds is that no one really knows what they’re worth.

So far, hedge funds, banks and other big investment funds have been carrying these bonds on their books based on what computer models tell them they should be worth. Now, with the Fed buying up these bonds and creating real market prices — some of these bonds are selling as low as 35 cents on the dollar — holders of this paper may be forced to take huge writedowns. And because much of this paper is held outside the banking system, no one — including the Fed — knows how big the hole it.

“The problem is now and over the next few weeks as these institutions mark things down,” said Mark Zandi, chief economist at Moody’ “That’s why investors are so skittish because they know — or they sense — that there’s more coming and they don’t want to have a line of credit or a loan out to an institution that announces on Monday or Tuesday that they’ve got to bail out of a fund, or close a fund. Or that they’re out of business themselves."

The Securities and Exchange Commission is reportedly looking into the books of several big l Street brokerages to find out how vulnerable they are to potential markdowns of bad mortgage-backed bonds.

More problems could occur as investors demand their money back — or bankers demand more cash to cover margin calls on loans used to buy the securities.

“There's a lot of forced selling going on,” said Robert Doll, chief investment officer for equities at BlackRock. “Leverage, when it goes in the other direction, is not a pretty thing. That's a lot of what we're witnessing.”

If the panic continues next week, the Fed said it is ready to step in and buy more troubled paper. But if the credit markets don’t calm down, the Fed may have no choice but to cut rates aggressively.

“At that point, they’ve used that tool in their tool kits and they have to go to something bigger,” Doll said. “You don’t want to risk not responding aggressively enough and have confidence completely coming undone.”

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