Federal Reserve officials anticipate economic contraction in the first half of 2008. Recently, Chairman Bernanke invoked rarely used authority to provide emergency financing for investment banks. Fed officials sought to limit the broad economic impact of what former Fed Chairman Alan Greenspan terms the worst credit crisis in 50 years. Central bankers cut the benchmark interest rate three-quarters of a point in March, for a total of 2 percentage points so far this year, the fastest drop in borrowing costs in two decades. The rate is now 2.25%, down from 5.25% in September.

“The problems of declining asset values, credit losses, and strained financial market conditions could be quite persistent, restraining credit availability and thus economic activity,” according to the Fed. Thus, the U.S. central bank took significant steps in March to increase the availability of credit:

  • Expanded its auctions of funds to commercial banks to $100 billion a month, up from $60 billion, and announced up to $100 billion in term repurchase agreements – thereby supplying more funds to banks at cheaper rates in order to induce easier lending
  • Voted to swap $200 billion of Treasuries in exchange for mortgage securities held by primary dealers – thus removing much of the mortgage market risk from Wall Street
  • Reduced the premium on direct loans to banks by a 0.25% and approved financing $29 billion of illiquid Bear Stearns assets to help facilitate a merger with JPMorgan – thereby preserving smooth operation of the US financial system
  • Opened a discount window for primary government bond dealers – thus staving off a run against large investment banks

These moves were designed to improve confidence in the financial system and increase the propensity of banks to lend to business and individuals. However, lending has not increased. Banks remain in retrenchment mode, grappling with the low valuations of their current portfolios and unwilling to add risk.

Losses to banks worldwide are nearly $300 billion since the start of the meltdown in global credit markets last summer. As a result, one bank after another is racing to raise capital – a total of $160 billion so far. UBS, which has written off more debt from the subprime crisis than any other bank, conceded that a blind drive for revenue led the Swiss financial giant to take more risks than it should have. Citigroup recorded more than $16 billion in write-downs and credit losses in the first quarter alone. Bank of America’s chief executive, Ken Lewis, sounded humbled by the bank’s third consecutive drop in quarterly earnings, telling investors on a conference call that “the current environment is the most challenging I have dealt with.”

Michael Ashley Schulman, CFA
Hollencrest Capital Management