Fed offers credit markets another $800bn bailout

The Federal Reserve is injecting $800bn (£518bn) more into the troubled credit markets in its latest high-stakes attempt to end the drought of mortgages, car finance deals and student loans that has pushed the United States into recession.

With three new plans announced yesterday, the Fed is massively increasing the scale of its intervention in the markets and inflating the size of its balance sheet. "Millions of Americans cannot find affordable financing for their basic credit needs," said the Treasury Secretary, Hank Paulson. "And credit card rates are climbing, making it more expensive for families to finance everyday purchases. This lack of affordable consumer credit undermines consumer spending and as a result weakens our economy."

Lenders have turned off the taps to consumers because of the collapse of the secondary market, where they used to sell on the loans and raise the cash needed for yet more lending. Loans are packaged together and sold as asset-backed securities (ABS) in a process called securitisation, but ABS buyers are demanding vastly inflated interest rates because of their concerns about the underlying economy, so issuance declined precipitously in September and came to a halt in October.

By offering $200bn in loans to ABS holders, the Fed believes it will stimulate demand and that securitisation will therefore restart. That, in turn, will encourage lenders to thaw their dealings with consumers.

"The ABS markets historically have funded a substantial share of consumer credit and small business loans. Continued disruption of these markets could significantly limit the availability of credit to households and small businesses and thereby contribute to further weakening of US economic activity," it explained.

To insulate the Fed from losses on its $200bn in ABS loans, the Treasury is handing the central bank $20bn from the $700bn Wall Street bailout fund agreed by Congress last month. Traders hailed the scheme as an ingenious way of using the Fed to "leverage" the bailout money, magnifying the effect of taxpayers' investment by 10 times. However, an early surge by stock markets subsided later in the day. The Dow Jones index closed up 0.4 per cent at 8,479.5.

Having already spent $270bn taking direct stakes in US banks and loaning $40bn to the nationalised insurance group AIG, there is just $20bn left in the first half of the bailout fund, and Mr Paulson may ask Congress to release the second $350bn tranche before he leaves office.

The $200bn ABS plan was the most unusual of the three major Fed programmes announced yesterday. It also said it would buy $500bn of mortgage-backed securities to support the mainstream mortgage market, and $100bn in debt issued by Fannie Mae and Freddie Mac, the government-controlled mortgage finance businesses. Both plans are aimed at propping up the secondary mortgage market, making home loans more readily available and reducing mortgage rates, which have remained stubbornly high despite repeated cuts in official interest rates.

The credit markets have been wrecked by the collapse of US house prices, which began a negative feedback loop that has still not ended. A glut of homes repossessed from sub-prime borrowers who could not afford the payments is still putting downward pressure on prices, it was clear yesterday. The latest Case-Shiller house price index showed values in 20 metropolitan areas down a record 16.6 per cent in the third quarter of the year and they are now back where they were in the early months of 2004.

Falling house prices have trashed the value of mortgage-backed securities and related assets on bank balance sheets, forcing banks to pull back on their lending activities – making things worse. "The turmoil in the financial markets is placing further downward pressure on a housing market already weakened by its own fundamentals," said David Blitzer, the chairman of the index committee at Standard & Poor's, which publishes the Case-Shiller figures.

The wider impact of the credit crisis was on display in other economic figures yesterday. The third-quarter GDP figure for the US was revised down to minus 0.5 per cent; the government had first calculated only a 0.3 per cent decline. Economists are bracing themselves for anything between -3 per cent and -5 per cent in the fourth quarter, representing the sharpest contraction in economic activity in at least 25 years.

With this week marking the traditional start of the holiday shopping season, much will depend on consumer confidence, which continues to be depressed, a new survey shows. The Conference Board confidence index, however, rebounded slightly from an all-time low of 38 in October to 44.9.

The Fed's new programmes yesterday came only a week after Mr Paulson said that there would most likely be no additional use of the Wall Street bailout fund until Barack Obama's administration takes over on 20 January, which sent markets diving. Traders most fear a prolonged power vacuum, but the Treasury said yesterday that Mr Obama's transition team had been kept involved in the latest plans. The $800bn intervention will be run mainly out of the Federal Reserve in New York, whose president, Tim Geithner, was named on Monday as Mr Obama's Treasury Secretary. Meanwhile, the President-elect yesterday named Peter Orszag to be his budget director, with a brief to slim down some government spending.