Credit plan produces a positive

Key interbank lending rate drops to lowest level in seven months

Fed chairman Ben Bernanke and FDIC chairwoman Sheila Bair listen as Treasury Secretary Henry Paulson discusses the plan to buy equity in banks. (Hyungwon Kang/Reuters)

Credit markets showed signs of loosening yesterday after the Bush administration unveiled its latest dramatic plan to break the financial crisis and pry open lending, including an unprecedented partial nationalization of the US banking system.

But stock markets ended a day of wild swings down slightly as mixed profit reports from companies showed the toll the credit crunch is taking on the US economy. The Dow closed down 76.62, or 0.8 percent, to 9,310.99, sapping the momentum from its record 936-point rally Monday.

Nine companies, including Boston's State Street Corp., will accept direct investments from the government, and in exchange the banks are expected to reopen lending and take other steps to restore confidence in the faltering economy.

The $250 billion planned purchase of shares in financial companies is equivalent to around 25 percent of the overall equity capital of the US banking system, Moody's, the Wall Street rating agency, said yesterday.

"Today's actions are not what we ever wanted to do," Treasury Secretary Henry Paulson ac knowledged yesterday. "Government owning a stake in any private US company is objectionable to most Americans, including me, yet the alternative of leaving businesses and consumers without access to financing is totally unacceptable."

Paulson described the nine as "healthy institutions" that had agreed to the government investment "for the good of the US economy." That said, he urged firms "not take this new capital to hoard it, but to deploy it." News accounts reported that Paulson had to pressure some firms to agree to the investment.

At Bank of America Corp., which will receive $25 billion, spokesman Robert Stickler predicted lending will be "a lot more than if we didn't have the capital," though he could not say by how much.

"There are two issues today: capital and recession," Stickler said. "This takes the first off the table. We still have to be careful to lend money we think the borrower can pay back."

Also yesterday, federal officials said the government will provide banks with temporary guarantees on new debt they issue, as well as FDIC insurance coverage for business customers' bank deposits. Both are intended to facilitate lending, with the former meant to encourage banks to lend to one another, and the latter to prevent the kind of rapid withdrawal of deposits that sapped Sovereign Bank and the failed thrift, Washington Mutual.

Federal Deposit Insurance Corp. chairwoman Sheila Bair said the bank lending-guarantee program in particular is a "profound and unprecedented action." It will cover up to $1.4 trillion in potential bank lending, she added, "one of the biggest things the FDIC has ever done."

Also, the Federal Reserve Bank fleshed out more details of a plan to buy commercial paper, which are short-term debts companies issue to fund routine operations, to help increase the flow of money through the economy. The central bank said it will begin purchases Oct. 27 and buy through April 30.

Taken together, the financial measures amount to the most sweeping economic rescue package in US history. The moves have put President Bush in the awkward position of having to explain a level of federal intervention that flies in the face of the small government philosophy he espouses.

"The government's role will be limited and temporary," Bush said yesterday. "These measures are not intended to take over the free market but to preserve it."

It appears the economic medicine is working where US officials most want it to: credit markets. A key rate for short-term lending between banks fell the most yesterday since mid-March, and rates on commercial paper fell to 1.72 percent, the lowest level in two weeks. Higher rates have made it more expensive, if not impossible, for businesses to borrow, causing a slowdown that many economists said has resulted in a recession.

That concern was reflected in the stock market yesterday as it digested news of shrinking earnings at major US companies. Microsoft Corp. and Intel Corp. slid more than 5 percent as analysts predicted slowing demand for computers. Pepsi Co. lost 12 percent, its largest drop since 1982, after lowering profit forecasts.

The bank-investment plan is intended to short-circuit a downward spiral leading to more corporate cutbacks, layoffs, and further contraction of the economy.

"This is our best shot at avoiding a deep recession," said Martin Baily, a senior economics fellow at the Brookings Institution. "Without this action, unemployment could rise to 7 or 8 percent, the kind of problem we haven't seen since 1982. This was something that needed to be done."

Paulson yesterday characterized the plan as the only way to restore confidence in shaky markets and the broader economy. But it doesn't have as many specific features as one rolled out by the British government last week to pump as much as $64 billion into major banks in that country.

Both plans included some limits on executive pay, including a US ban on so-called golden parachutes at banks that sell shares to the government. But the British plan went further, such as requiring banks to maintain lending at 2007 levels.

While US officials said they would be passive investors, Paul Weinstein, a senior fellow at the Washington-based Progressive Policy Institute, questioned whether the government would try to dictate policies at these companies.

"You don't want the government micromanaging these companies down the road," he said.

But Philip Strahan, a finance professor at Boston College, said he doesn't expect government officials to be active in these companies. "All they want to do is get enough capital into the system that people will lend to each other again," he said.

The Treasury will purchase preferred shares in companies and hold them for at least three years. The banks will pay dividends on those shares, and be able to buy them back at the offering price after three years, or sooner if they raise private capital. The government also receives rights to buy common shares in the firms and would be in a position to profit if the values of the companies increase over time.

Nine major companies so far will participate in the program: State Street Corp., Citigroup Inc., Wells Fargo, JPMorgan Chase & Co., Bank of America, Morgan Stanley, Goldman Sachs, Merrill Lynch, and Bank of New York Mellon Corp. State Street Corp, will receive $2 billion from the government.

Casey Ross can be reached at cross@globe.com. Ross Kerber can be reached at kerber@globe.com.