Markets Crisis Tests Resolve Of Fed, Officials
                                                              by Greg Ip, Deborah Solomon & David Wesel

    As an academic, Federal Reserve Chairman Ben Bernake studied the policy mistakes that led to the Great Depression and the ways dislocations in financial markets can affect the rest of the economy.
    Now he is getting a chance to put theory into practice.
    Amid strained credit markets and a volatile stock market, the Fed, the European Central Bank and their counterparts in other parts of the world last week pumped billions of dollars and euros into money markets to keep short-term interest rates from rising as demand for short-term funds overwhelmed the supply. It was the biggest such maneuver since the Sept. 11, 2001, terrorist attacks.
    For its part, the Bush administration declined to lift regulatory limits on mortgage giants Fannie Mae and Freddie Mac to allow them to buy more mortgages. President Bush and Treasury Secretary Henry Paulson instead sough to bolster confidence, a key commodity at times like this, by emphasizing the fundamental strength of the global economy.
    How Mr. Bernake and authorities around the world respond in the days ahead will affect whether the crisis passes without lasting damage or deepens to the point where the Fed and other central banks set aside anxieties about inflation and reluctance to appear to be bailing out investors who mad bad bets.
    What more can policy makers and regulators do? The next step would be for the Fed to cut interest rates to make borrowing cheaper -- affecting banks, hedge funds, businesses, holders of adjustable-rate mortgages and consumers -- and credit more available. Overseas, the European Central Bank, Bank of England and Bank of Japan could defer previously anticipated rate increase.
    A serious deterioration in  markets of a rate cut even before the Fed's next scheduled meeting, Sept. 18. If the situation doesn't improve, a Sept. 18 rate cut is likely.
    But if markets stabilize and credit begins to flow normally, as Fed officials hope, the central bank is likely to hold its key rate at 5.25% a while longer to fend off inflation. The bank of Japan is set to weigh rates next week and the ECB on Sept. 6.
    Today's turmoil is creating obvious comparisons to 1998. Then, a financial crisis at first crippled emerging Asian economies without threatening the U.S. or other Western economies. But when Russia devalued its currency defaulted on foreign debts in August, it sent a shock wave through global markets.
    In early September, then-Fed Chairman Alan Greenspan declared the U.S. couldn't "remain an oasis of prosperity unaffected by a world... experiencing greatly increased came to a near half. The New York Fed organized a rescue of LTCM, and the Fed cut interest rates by three-quarters of a percentage point between late September and mid-November. The U.S. escaped recession.
    Whether today's credit crisis looks as bad is a subject of intense dispute. "In 1998, a lot of the big boys were really scared," said a former government official and veteran of '98. "Right now a lot of the big boys are saying, 'How can I profit from this?' That feels a little different." Big corporations -- such as Merrill Lynch, Kraft Foods, Citigroup, IBM even Bear Stearns & Co. -- have able to sell debt recently.
    By one quantifiable indicator, the 2007 episode isn't yet as severs as 1998. When markets are stressed, investors pay more for the most liquid, or most easy to sell, securities. In 1998, the spread between yields on the most heavily traded Treasury debt -- the easiest to sell -- and less heavily traded, but still secure, Treasury issue widened by more then two-tenths of a percentage point. That was a huge gap that showed just how risk-averse investors had become. In recent weeks, the analogous spread has widened less than two-hundredths of a percentage point.
    But comparisons are difficult. The greatest stresses today are in markets that were far less important in 1998. Their evolution since then has made it much harder for regulators or Wall Street CEOs to know precisely where the risks lurk.
    WSJ's Phil Izzo and David Wessel, and David Resler, chief economist of Nomura Securities, talk about the global credit and the Fed's pledge to inject more liquidity into the markets, Among today's big fears: that commercial and investment banks, thinking they have used derivatives to lay off the risk of defaults, will discover they effectively bought insurance from hedge funds whose financial survival depends on credit from those same commercial and investment banks; that big firms are exposed to troubled markets in ways they don't realize or haven't disclosed; or that players with heavy borrowing will have to dump their holdings and make everything worse.
    One unusual feature of the current crisis is that the problems started in the U.S. -- in the subprime mortgage market -- but seem to be most acute in Europe. Consequently, the ECB has been more aggressive than the Fed in putting money into markets to relieve strains. The German government, not the U.S., has had to organize the rescue of a troubled institution, IKB Deutsche Industries Bank AG, which had invested heavily in U.S. mortgage-banked securities.
    Today's crisis, in large part, reflects an inability to accurately value collateral -- such as pools of mortgages -- and uneasiness about the computer models used to value complex securities. That leads those who have money to insist on higher rates and tougher terms, and in some cases to keep more money in reserve just in case.
    The authorities' goal isn't to stop prices of stocks, bonds and mortgage-backed securities from falling as the market reassesses risk. It is to prevent either a generalized loss of confidence that freezes markets or a generalized credit crunch in which even credit-worthy borrowers can't get loans.
    In an unusual move that reflected unusual circumstance, the Fed last week encouraged dealers through which it operates to offer government-guaranteed mortgage-backed securities alone as collateral for short-term loans instead of the usual custom of using them with Treasury debt and bonds issued by Fannie Mae and Freddie Mac. The Fed hasn't done that at all this decade.
    The move sparked some speculation that the Fed was trying to prop up the price of mortgage-backed securities. In a statement Friday, the Federal Reserve Bank of New York cited a desire for "operational simplicity." Outside analysts said the Fed was trying to make it easier for dealers to finance their inventories of mortgage-backed securities and possible to avoid aggravating a possible shortage of Treasurys available for use as col-lateral.
    Officials outside the Fed, aware that their most significant contribution may be to avoid undermining public and investor confidence, have been careful not to suggest anything approaching panic. Mr. Bush took of on a planned vacation. Christopher Cox, chairman of the Securities and Exchange Commission, is on vacation in Alaska, though in touch with his staff. Mr. Paulson did two television interviews on Wednesday, and has been invisible since.
    The market turmoil prompted the President's Working Group on Financial Markets -- the Treasury, the Fed, the SEC and the Commodities Futures Trading Commission -- to trigger protocols established by Mr. Paulson shortly after he took office last year. They include a detailed list of who is going to call fincial institutions, risk managers traders and chief executives to keep tabs, how often they should call and the like. When he first joined Treasury from Goldman Sachs, Mr. Paulson instructed Emil Henry, then the Treasury official in charge of financial institutions, to craft guidelines for five or six "meltdown" scenarios. One was a catch-all "General Withdrawal from Risk Taking." Others include a liquidity crisis, stock-market meltdown and oil stock. The Working Group has held conference calls, principally among staff, at lest once a day in recent days.
    Predominant Worry
    Just last Tuesday, at a regularly scheduled meeting, the Fed decided to leave rates unchanged and reasserted that its predominant worry remains inflation. Since then, credit markets have grown tighter, and problems have spread from subprime mortgages to larger mortgages and asset-backed commercial paper. "If credit is becoming more restricted... and the Fed doesn't do anything, it is accommodating a tightening," said Ray Stone of Stone & McCarthy Research Associates.
    Some Fed officials worry a rate cut now might suggest the bank is focused on the markets rather than on the economy. Others see a growing economic justification for easing.
    Some analysts suspect Mr. Bernanke, who has been in office for 18 months, will be reluctant to cut rates in order to expunge belief in the "Greenspan put" -- Wall Street's term for the perceived readiness of his predecessor to cut rates and bail investors out of bad decisions. (A put option protects its holder against investment losses.) Senior Fed officials insist the Fed never acted that way, noting that is raised rates in 1994 even though that inflicted damage on the bond market and it didn't protect stock-market investors from heavy losses early in the 2000s. Mr Bernanke, they say, will be motivated by conventional considerations: growth, inflation and financial stability.
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