Central banks make $250bn move to ease the credit crisis

Joint action by US, UK, Europe and Canada; Dow Jones surges on news

Central banks around the world made a second co-ordinated attempt to ease the credit crisis, three months after their first efforts failed to kickstart lending across the financial system.

After days of gathering fears that falling mortgage bond prices could trigger a wave of forced selling by highly indebted hedge funds and other investors, the Federal Reserve said that it would lead a global effort to inject around $250bn (£125bn) of replacement securities into the system.

The Bank of England, the European Central Bank and the central banks of Switzerland and Canada also joined the effort, which stoked a rally by battered stock markets yesterday.

The Fed is to auction $200bn of US government bonds – the safest debt securities available – and will take in unwanted mortgage bonds as collateral. A collapse in the value of these mortgage bonds was behind last week's market turmoil, as fears grow that even apparently robust mortgages could go into default if the US economy falls into recession and borrowers lose their jobs.

The latest actions come on top of last Friday's announcement that the Fed is increasing the size of its so-called "term auction facility", an emergency facility introduced in December that lends cash directly to the banking system, by $140bn.

Behind all the central bank's innovative moves is an attempt to flush the financial system with money and safe government bonds so that banks will feel comfortable lending to each other. Banks that have too many volatile mortgage bonds on their books, whose value is uncertain, have been reluctant to continue lending at historic levels. As a result, highly leveraged hedge funds are being told to sell assets to meet margin calls, and the cost of borrowing has risen across the financial system, threatening to make it more costly for even robust businesses to invest. That in turn threatens turning a fin-ancial crisis into a trigger for a recession in the real economy.

"Since the co-ordinated actions taken in December 2007, the G-10 central banks have continued to work together closely and to consult regularly on liquidity pressures in funding markets," the Fed said yesterday. "Pressures in some of these markets have recently increased again."

The Bank of England said it would lend another £10bn in cash to the banking system, in return for a wider range of collateral that includes mortgage-backed securities, extending a facility that it offered as part of December's co-ordinated efforts. The new three-month loans will be offered next week, with another offering of an as yet undetermined size to follow in April. The ECB is to make $15bn available.

Meanwhile, the Fed is expanding currency "swap lines" with the ECB and the Swiss central bank, respectively, sending them dollars that can be lent to troubled European banks. A dwindling of dollar assets in Europe has contributed to the high inter-bank interest rates being charged for dollar-denominated lending, particularly the closely watched London inter-bank lending rate, Libor, off which many other types of loans are priced.

Stock markets jumped on the announcement of the co-ordinated moves. The FTSE 100 closed up 61.3 at 5,690.4 in London. The Dow Jones Industrial Average closed up 417 points, or 3.6 per cent, at 12,156.8 in New York. The dollar also rose and in the credit markets, investors moved out of safe assets such as Treasuries into riskier debt instruments.

Analysts were split on whether the moves might be enough to end the downward spiral in the debt markets. Joseph Brusuelas, economist at IDEAglobal, said: "By permitting borrowers to put up devalued collateral that currently contaminates the balance sheets of financial institutions, this should provide a generous bout of temporary relief to portfolios overweight with distressed assets. But we do not see this as a panacea. For now, the current Fed move will purchase a fortnight of peace."