Fed to give lenders an $800b lift

New infusion brings concern about inflation

Treasury Secretary Henry Paulson said regulators are prepared to use all the tools at their disposal to stabilize the system. (Mark Wilson/Getty Images)

After pumping more than $1.5 trillion into the US financial system, the Federal Reserve will now commit another $800 billion to revive struggling mortgage, housing, and consumer credit markets and moderate a deepening economic downturn.

The Fed said yesterday it would essentially lend $100 billion to mortgage giants Fannie Mae and Freddie Mac and to Federal Home Loan Banks, and buy $500 billion in mortgage-backed securities guaranteed by Freddie, Fannie, and another government-sponsored company, Ginnie Mae. The central bank will also lend another $200 billion into the consumer market, taking as collateral securities backed by student loans, credit cards, and other consumer credit.

With the new $800 billion program, the Fed will have pumped about $2.5 trillion into the financial system, the equivalent of one in every four dollars spent annually by US consumers. This unprecedented stimulus poses a risk of rapid inflation if the Fed does not pull out of the program fast enough once the economy recovers, economists said.

"What's startling is how blase we've become about these vast sums of money," said Bill Cheney, chief economist at John Hancock Financial in Boston. "Not long ago, this was called unconventional monetary policy, but now we're getting used to it."

The goal of the Fed's latest action, one of the biggest yet, is to provide more money to banks, encouraging them to make loans at lower rates to consumers buying homes, cars, and other goods. Mortgage and other lending rates have remained stubbornly high as banks, worried about getting repaid and weathering the economic downturn, have held onto cash instead of making loans. After the Fed announced the plan, mortgage rates fell by as much as three-quarters of a point, to around 5.5 percent, according to Bankrate.com.

"This could lower the cost of mortgage finance at a time when it's really needed," said Bob Davis, executive vice president at the American Bankers Association. "If well-executed, it could provide liquidity without exposing the government to too much loss."

Liquidity is the term used to describe the flow of money from lenders to borrowers. Since the financial crisis began more than year ago, the flow has slowed to a trickle, cutting off credit that businesses need to operate, expand, and hire, and that consumers need to buy homes, cars, and other goods.

As a result, what began as a moderate economic slowdown has spiraled into what many economists say could become the worst recession since the end of World War II. Yesterday, a leading housing index showed home prices in major metropolitan areas, including Boston, plunging a record 17.4 percent in September from a year earlier. The Commerce Department, meanwhile, reported economic activity declined at an annual rate of 0.5 percent in the quarter that ended on Sept. 30, the fastest rate since 2001.

Many economists expect far worse performance in the current quarter. Research firm IHS Global Insight of Waltham, for example, forecasts the economy will have shrunk at an annual rate of 4 percent by the time the quarter ends Dec. 31.

"It's going to be bad," said Nariman Behravesh, chief economist at IHS Global Insight. "It's clear the Fed is shouldering most of the burden of getting us out of this mess."

The Dow Jones industrial average rose 36.08 points to close at 8,479.46; the Nasdaq fell 7.29 to 1,464.73.

The Fed's new program is the latest in a series of extraordinary actions by the central bank to keep credit flowing through the financial system and prevent a catastrophic collapse. Those actions have included engineering the sale of failing investment firm Bear Stearns Cos. by guaranteeing about $30 billion of its troubled assets; rescuing insurance giant American International Group with more than $100 billion in loans; and providing hundreds of billions of dollars in short-term loans to banks and securities firms.

The Fed has slashed the federal funds rate, which banks charge each other for overnight loans, to 1 percent, and many economists expect Fed policy makers to cut rates again to an all-time low of 0.5 percent when they meet next month. Despite these aggressive cuts in the federal funds rates, which typically influence the interest charged for a variety of loans, other rates have barely budged.

For example, the average US mortgage rate was just over 6 percent last week, according to Freddie Mac, essentially unchanged from the beginning of the year, even thought the Fed has cut 3.25 points since then.

The Fed's $800 billion program is aimed at bringing rates down by making more money available to lend. The money Freddie and Fannie will receive will allow them to buy more mortgages from banks, freeing up money for banks to make more loans.

Buying mortgage-backed securities from other institutions will also provide more money for them to lend. Mortgage-back securities are financial instruments in which many mortgage loans are packaged together and sold to investors, who recoup their investment as homeowners make payments. A few years ago, high volumes of mortgage-backed securities were bought and sold, providing a flow of capital that fueled mortgage and housing markets. Buyers of these securities have all but vanished in the wake of soaring loan defaults.

The Fed, in this case, is acting as buyer of last resort.

Sheila Bair, chairwoman of the Federal Deposit Insurance Corp., gave guarded support to this Fed plan. "Any tools that can be used to ease the stress in housing finance are still good," Bair said in an interview yesterday.

At the same time, Bair voiced frustration that the government has not approved an FDIC plan to spend $25 billion to help prevent foreclosures by systematically modifying mortgages to help make payments affordable for people who have fallen behind on payments. "It has been a frustration for me we haven't been able to come to grips with the underlying problem which is the mortgages," she said.

Robert Gavin can be reached at rgavin@globe.com.