- The Washington Times - Wednesday, October 29, 2008

The Federal Reserve Wednesday slashed interest rates by another half percentage point to try to prop up the rapidly sinking economy while it agreed to extend short-term loans to the finance arms of all of Detroit’s Big Three automakers.

The central bank’s latest acts of largesse come as threats to the economy from major bankruptcies among the automakers and other businesses have been escalating, while the Fed has made scant progress at unfreezing locked credit markets that are choking debt-dependent consumers and companies alike.

GMAC, the lending arm of GM, and its counterparts at Ford and Chrysler have been largely shut out of credit markets since mid-September, making it difficult or impossible for them to offer loans to consumers who want to buy cars. Many auto dealerships have had to shut down because they could not obtain financing for their inventories of cars for sale.

The automakers’ sales have plummeted to the lowest levels in decades and GM has been fast running out of cash. Both GM and Chrysler — among the largest employers in the United States — are believed to be heading toward bankruptcy unless their access to credit is restored or they receive help from the federal government.

While the auto companies are bankruptcy risks, they have unquestioned importance to the economy. By one estimate, one in ten American jobs are tied directly or indirectly to auto manufacturing, the companies account for nearly nearly half of U.S. retail sales, and contribute powerfully to overall growth in the economy.

The Fed has essentially agreed to become a lender of last resort to the companies, despite their poor credit ratings and prospects. Using authorities not invoked since the Great Depression, the central bank already has taken on the role of lender to top-rated corporations like GE that issue commercial paper, as well as much of the financial system outside the Fed’s traditional banking bailwick, including Wall Street firms and insurance companies.

“The Federal Reserve and Treasury Department are in a kitchen sink mode,” said Richard Yamarone, economist at Argus Research Corp. “Anything and everything is getting tossed at the crisis whether or not it makes economic sense.”

John Silvia, economist with Wachovia Securities, said the Fed is having to “make lemonade out of lemons” with its increasingly extreme efforts to aid the economy and pry open credit markets.

“There simply is no easy out for the financial markets, the economy or policymakers,” he said. “The great American financial work-out continues.”

The possibility of getting financing from the Fed did not prompt Standard & Poor’s Wednesday to raise its opinion of the auto companies or their prospects, however.

“New access to funding could slow the erosion of these companies’ liquidity,” said Standard & Poor’s credit analyst Robert Schulz, but is not “a panacea for these companies’ credit concerns.”

He noted that government financing is likely to be accompanied by a requirement that the car companies radically restructure to cut costs, or even a mandate for one or the other to file a “strategic bankruptcy” that could bring “rapid and massive changes” for company employees, creditors and the economy at large.

“Our most fundamental and serious concerns regarding GM and Chrysler remain unchanged,” Mr. Shulz said, citing “pressures on liquidity facing both automakers and their auto finance affiliates during the rest of this year and 2009, caused by the rapidly weakening state of most global automotive markets and continued turmoil in the credit markets.”

Beyond borrowing from the Fed, GMAC hopes to gain access to Treasury cash by applying to become a bank holding company. If the Fed approves the auto company’s bank application, it would have unlimited access to Fed loans and would become eligible for a capital infusion from the Treasury’s $250 billion bank recapitalization fund.

The loans the Fed plans to make to GM and others through the commercial paper program that got underway this week are unsecured — that is, the Fed does not take collateral in case the corporations are unable to make good on their loans. All of the auto companies have been downgraded far into junk credit status recently by Standard & Poor’s and other Wall Street ratings agencies, which deem them to be among the shakiest credit risks. That is a major reason they have been unable to get loans from private investors.

The Fed is in a very difficult position trying to protect the economy and revive moribund markets, and its actions show it is getting increasingly desperate, said Sung Won Sohn, economics professor at the University of California.

“The central bank is using the ‘Door Knob Policy’ where collateral requirements have been loosened significantly, i.e. the door knob could be used as collateral if necessary,” he said. “This is a very powerful tool; the Federal Reserve can lend money to almost anybody through the window and it does not require Congressional approval.”

The Fed’s move to slash the rate on overnight loans to banks by a half percentage point to 1 percent also shows the extremes it is willing to go to prevent a deep recession in the United States, Mr. Sohn said.

“The interest rate controlled by the Federal Reserve is headed to zero in a few months,” he said. “The willingness to lower the interest rate to something approaching zero is a very momentous decision. Rarely in its 95-year history, has the central bank put itself in this position. The Federal Reserve has to use everything it has to prevent the wild fire from growing.”

While the rate cut should support confidence in financial markets and lower borrowing costs for consumers and businesses, it exposes a crucial problem as it leaves the Fed with very little room to lower rates further should the economic slump prove to be deep and long, Mr. Sohn said.

“The central bank could be viewed as an ‘Emperor With No Clothes’ as it runs short of ammunition,” he said.

The Fed said it was cutting rates out of concern about a sharp slowdown in consumer spending, which it said could be worsened by the turmoil in the stock market and freeze in credit markets in recent weeks.

Economists estimate that consumer spending, which fuels 70 percent of economic activity, is falling at a 2.5 percent rate after adjusting for inflation. On Tuesday, the Conference Board reported that consumer confidence plunged by the most on record amid worries about disappearing stock wealth and jobs.

Even consumers who would like to spend are having trouble doing so because of a shortage of credit available from banks, the Fed noted.

“It is clear that the Fed is greatly concerned with the consumer sector,” said Argus’ Mr. Yamarone, but it “is getting to the point where they are running low on ammunition.”

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