Fed Aiming to Block 'Meltdown' that Could Affect All Americans

WASHINGTON — Haunted by the specter of a financial "meltdown," Federal Reserve policy makers are taking drastic steps to ease a nationwide credit crunch. They could continue Tuesday with another large interest rate cut.

Bank regulators fear that the failure of a major financial institution could trigger a vicious cycle. Losses could cascade from one bank to another, frightening away investors and making it impossible for businesses to raise capital through loans, stocks or bonds. That would reverberate into the wider economy, killing jobs for ordinary Americans and deepening the housing crisis.

"Any time you have had a financial meltdown in history it has impacted all of the United States, because so much of the economy depends on the free flow of credit," said John Silvia, chief economist for Wachovia Corp., a Charlotte, N.C.-based banking company.

The Federal Reserve sought to avoid just such a scenario Sunday with its strongest actions in decades. It opened its "discount window" for direct loans from major investment houses and put a $30 billion line of credit behind the sale of Bear Stearns Companies Inc. to another New York investment bank, JPMorgan Chase & Co.

The moves showed that policy makers are responding quickly to deal with the nation's "challenging times," President Bush said at a meeting of his top economic aides.

"The United States is on top of the situation," Bush said. "The Federal Reserve has moved quickly to bring order to the financial markets."

Treasury Secretary Henry Paulson praised the Fed's efforts to keep Bear Stearns out of bankruptcy, saying after another White House meeting with Bush that the action recognized "the importance of orderly markets, stability in our financial system."

Bear Stearns got into deep trouble by dealing too heavily in securities tied to subprime mortgages, which are offered to borrowers with low incomes or poor credit histories. As more and more homeowners defaulted on those mortgages over the past two years, Bear Stearns' losses have mounted.

Last week, nervous clients started demanding their money back, and other firms on Wall Street effectively stopped dealing with Bear Stearns, fearing the company could not keep up its end of bargains.

"The fear was that if Bear Stearns were to go under, it could suck up money that other banks had invested in it," said Christian Weller, an economics professor and senior fellow at the Center for American Progress, a research group. Then those other banks would get weaker, making their clients nervous, he said.

"You could have a ripple effect that could cause a total panic," Weller said. "As people panic, they pull money out of financial institutions."

The ultimate nightmare scenario would involve a panic spilling over into retail banks, where average Americans keep their checking and savings accounts.

Those institutions generally are very safe from bank runs because the federal government insures deposits up to $100,000. But given that bad investments in subprime securities also have been battering retail banking companies such as Citigroup Inc., which has more than 3,000 bank branches, a slight risk of bank runs does exist.

"Given the way sectors are interlinked, risks should not be underestimated," said Adrian Cronje, director of asset allocation for Wilmington Trust Co., a Delaware-based banking company. "I would hesitate to say that any one sector (such as retail banking) is immune."

But he was careful to add that most banks are very sound. Even in a meltdown, "not everyone would be affected," he said. "There are institutions that haven't done anything stupid," such as overinvest in subprime mortgages.

Still, the Federal Reserve is highly motivated to interrupt any potential downward spiral. So when its Federal Open Market Committee meets Tuesday, the policy makers are expected to continue slashing short-term interest rates, as they have since September.

As fears about the financial stability of major companies has grown, so have estimates about the size of the Fed rate cut. Earlier this month the number most often mentioned was a half a percentage point. But now some foresee a cut of a full point in the target federal funds rate to 2 percent, not far from its recent low of 1 percent in 2003.

While the independent Fed has been active, the Democratic presidential candidates have been harshly criticizing the Bush administration for failing to act sooner to burst the subprime bubble.

Sen. Hillary Clinton, D-N.Y., told reporters Monday the nation is in "a moment of great unique uncertainty in our financial markets."

Clinton said that unlike the Bush administration, she would have called together key economic players, and "we would have stayed in one place until we had a resolution about what we were going to do" to fix the subprime mortgage mess.

"Now we are in the soup, and we'd better get ourselves out of it before the consequences are drastic," she said.

Sen. Barack Obama, D-Ill., described the U.S. economy as being "in a shambles."

At a town hall meeting in Pennsylvania, he said his prescription for reviving the economy included a tax-cut for the middle class.

"The problem we have right now is not that the wealthy don't have enough tax breaks. The problem is ordinary Americans don't have spending power," he said.

Cox Newspapers White House correspondent Ken Herman contributed to this article.