Washington With triple-digit declines in financial markets unnerving investors, the Federal Reserve quickly pumped $38 billion into credit markets Friday in a move designed to prevent the world's financial system from freezing up.
The move soon helped lift Wall Street out of its funk, and the Dow Jones industrials ended the week up 58 points, or 0.4 percent.
So, what does it all mean? Here are some questions and answers about the Fed's intervention, and what it portends for investors, institutions and the future of the economy:
What exactly did the Federal Reserve System do?
Through complicated repurchase agreements, the Fed effectively pumped $38 billion into credit markets to defend the current interest-rate structure. Its benchmark federal funds rate, which influences consumer and business loans, is set by market forces and had risen to 6 percent Friday morning. That's well above the 5.25 percent target that the Fed's policy-making Open Markets Committee had set Tuesday. The Fed move brought the federal funds rate back to previous levels.
How did its action help banks?
In the United States, Europe and Asia, central banks fear that lending might cease because lenders are increasingly afraid to take risks in today's volatile environment. The Fed's action, along with similar moves by the European Central Bank and others, tells banks that money is available if it's needed to ensure that overnight bank lending and other routine transactions can continue.
What does all this have to do with housing?
At the root of today's uncertainty are poorly performing home loans, mostly those given to borrowers with weaker credit histories or who have overextended themselves by taking on large amounts of debt. These so-called subprime loans are going into delinquency and default at alarming rates, and the worst of the problem is still ahead. The real problem loans are expected late this year and throughout next year. Housing and financial analysts think that lenders dangerously weakened lending standards in late 2005 and 2006, when there was a flurry of issuing exotic home loans and adjustable-rate mortgages. Many of these loans are due to bump up to higher interest rates late this year and next year. And since home prices are falling or stagnant, and banks wary of lending, these loans may prove hard to refinance.
Why does Wall Street worry about subprime loans?
Years ago, banks held home loans on their balance sheets. Today, they're sold on the secondary mortgage market, where they're pooled together, bundled and sold to investors as so-called mortgage-backed securities. The big investment banks such as Bear Stearns, Lehman Brothers and others are deeply involved in this, and also may have extended credit to some of the buyers of these securities. Generally, better-quality loans are sold to Fannie Mae, the quasi-government agency that does some of this packaging. The riskier loans have been issued by so-called private label issuers, Wall Street firms who sell these bonds to investors here and abroad.
Who holds these riskier mortgage securities?
That's not entirely clear, adding to today's market volatility. It's thought that lightly regulated hedge funds, which control huge pools of investment money, own many of them. Average Americans increasingly have a stake in hedge funds because public and corporate pension funds plunk portions of their portfolios into them. Foreigners are exposed, too. France's largest bank, BNP Paribas, on Thursday froze three investment funds that held mortgage bonds and other exotic U.S. bonds.
Is a U.S. government bailout coming?
President Bush said this week that he didn't want to bail out lenders but was willing to help borrowers. The problem is that helping borrowers lets lenders off the hook. Fannie Mae has asked the federal government to allow it to expand its mortgage holdings by 10 percent. This would allow Fannie Mae to help some troubled homeowners refinance into manageable loans. Bush wants revisions to Fannie Mae before homeowners are rescued; Democrats want quicker action.
Does this mean a recession is ahead?
Bush and his economic team are talking up the economy and saying that the fundamentals remain strong. Most economists think the housing sector's problems will shave a full percentage point of growth from the economy this year. As long as employment indicators remain strong and consumer confidence robust, there shouldn't be a recession. But if credit problems in the banking sector become a full-blown credit freeze and people can't get loans to buy homes or cars or to start businesses, the economy would be hit hard.
What will happen to my 401(k) plan or my individual retirement account? What should I do?
Most financial advisers suggest taking a long view on investing. They think that despite the short-run turmoil and gyrations, stocks are a good investment over a longer period. To be sure, individual stocks and mutual funds are going backward right now, but the stock market is still up 6.2 percent for this year. Many analysts think that a 10 to 15 percent price correction has been in order, suggesting that further dips are ahead. If you're uneasy about how the recent volatility affects your retirement assets, it may be a good time to consult an expert.