- The Washington Times - Thursday, October 30, 2008

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

The central bank acted as major bankruptcies among automakers and other businesses escalated threats to the economy. The Fed has made scant progress, meanwhile, at thawing frozen credit markets that are choking debt-dependent consumers and companies alike.

GMAC, the lending arm of General Motors Corp., 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 customers. Many auto dealerships have had to shut down because they could not obtain financing for their inventories.

The automakers’ sales have plummeted to their 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 thought to be heading toward bankruptcy unless their access to credit is restored or they receive federal assistance.

While the auto companies are bankruptcy risks, they have unquestioned importance to the economy. By one estimate, one in 10 American jobs is tied directly or indirectly to auto manufacturing. The companies account for nearly half of U.S. retail sales and contribute powerfully to overall growth in the economy.

The Fed essentially has 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 has taken on the role of lender to top-rated corporations like General Electric Co. that issue commercial paper, as well as much of the financial system outside the Fed’s traditional banking bailiwick, 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, an 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 workout continues.”

The prospect of federal financing did not give the auto companies a higher opinion from Standard & Poor’s.

“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.

Chrysler and GM were reported to be near a deal to merge Wednesday in a combination that likely would result in the closure or bankruptcy of Chrysler. The deal depended on getting an estimated $10 billion in financing from the government or other sources. While the Fed’s loans technically go to the companies’ finance arms, the money can be used for any purpose.

“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 under way 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 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 California State University.

“The central bank is using the ‘doorknob policy,’ where collateral requirements have been loosened significantly, i.e., the doorknob 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, Mr. Sohn said.

“The interest rate controlled by the Federal Reserve is headed to 0 in a few months,” he said. “The willingness to lower the interest rate to something approaching 0 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 wildfire 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 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 annual 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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