Major U.S. stock indexes ended higher on Wednesday, but not before swinging from an apparently euphoric response to Bernanke & Co.'s plan for more creative steps to ease the liquidity crisis to a reversal into negative territory on nervous thoughts that it may be too little too late to address widening contagion in the financial markets.
Through coordinated action with a handful of other central banks, the Federal Reserve will employ at least $64 billion in auctions and foreign exchange swaps to grease the wheels of the global financial system.
On Wednesday, the Dow Jones industrial average epitomized the whipsaw action we've come to expect from equity markets in recent months. The U.S. blue-chip benchmark swung nearly 400 points from an early 271-point gain to a 95-point loss at the start of the final hour of trading. But the dramatics weren't done: The Dow clawed its way back near the close to end 41.13 points, or 0.31%, higher at 13,473.90. The broader S&P 500 index rose 8.94 points, or 0.61%, to 1,486.59. The tech-heavy Nasdaq composite index gained 18.79 points, or 0.71%, to close at 2,671.14.
Equity indexes retreated from their highs amid questions about why the Fed waited until Wednesday to announce the plan, S&P MarketScope said. A senior Fed official said the plan was the result of weeks of work coordinated with other central banks, which wanted the announcement made when all banks were open. The official said the announcement had nothing to do with the negative reaction to the rate cuts on Tuesday, CNBC Business News reported. Selling into earlier strength of financial stocks also contributed to the pullback from the highs.
But some market observers refused to accept that explanation and that has the market heading into year-end with questions about the Fed and uncertainty about the economy, causing many portfolio managers to close their books for the year, S&P MarketScope said.
On the New York Stock Exchange, 17 stocks traded higher for every 13 that lost ground in a volatile session, while the ratio on the Nasdaq was 15 to 14 positive amid active trading. Financial stocks took another drubbing, led by Citigroup (C).
Although the market wanted to view the Fed's new plan as proof the central bank is on top of the credit issues, there's a growing realization it may be too late to reverse the spreading contagion of bad loans, restricted lending and damage to the U.S. economy, said Joe Battipaglia, a market strategist at Stifel Nicolaus. That, coupled with bad news about additional loan loss provisions from Bank of America (BAC) and Wachovia Corp. (WB) wiped out any lingering optimism and put stocks on the defensive, he said.
"This isn't just about subprime and subprime-related issues. It's about what's happening to lines of credit for prime borrowers and Alt-A buyers, what's happening to credit card balances," he said. "What you see happening here is a very fast-spreading contagion amongst all forms of credit related to the consumer that are turning bad at an accelerated rate."
From that perspective, market observers are equating the Fed's actions with those it's taken in prior times of severe distress, such as in the wake of 9/11, Battipaglia added. "They must mean that the situation is so dire that they would look at a coordinated way with other central banks to flood money into the global market."
Investors had dumped stocks Tuesday afternoon, frustrated that the Fed did not seem to be taking the credit crisis seriously enough with 25 basis-point cuts in the federal funds and discount rates. About a half hour before the start of Wednesday's trading, the Fed announced some innovative actions designed to ease the liquidity crunch.
The Fed said it's setting up a temporary Term Auction Facility that will allow the Fed to auction term funds to depository banks against the wide range of collateral that can be used to secure loans at the discount window.
All depository banks judged to be sound financially by their local Reserve Bank and that are eligible to borrow under the primary credit discount window program will be permitted to participate in these auctions.
The Federal Open Market Committee, the Fed's policy arm, has also authorized setting up temporary foreign exchange swap lines, initially for a total $24 billion, with the Bank of England, the Bank of Canada and the Swiss National Bank that will enable European banks to go through European central banks to satisfy their dollar reserve needs rather than having to get them directly from U.S. Reserve banks. The swap lines have been approved for a period of up to six months.
The Fed's first auction for $20 billion will take place on Dec. 17, with a second auction of up to $20 billion slated for Dec. 20. The funds from those auctions will mature on Jan. 17 and Jan. 31, 2008, respectively. Two additional auctions have been scheduled for January.
The moves are intended to provide more liquidity to tight financial markets and are specifically targeting the Libor rate, on which most U.S. homeowner adjustable-rate mortgages due to reset are based and which continues to rise. The hope is that the auctions will attract bidders among the banks who hesitated to take advantage of the discount window, as this takes the stigma out of such discounted term loans, CNBC said.
Although the nominal rate of the one-month London interbank offered rate, or Libor, remains lower than it was in early September, the problem is that the Fed isn't getting a one-for-one shift lower in Libor for each of its easing moves, said T.J. Marta, a fixed-income strategist at RBC Capital Markets. When the Fed cut the Fed funds rate by 25 basis points on Tuesday, the one-month Libor rate only dipped by 10 basis points, he said.
"The lag is that banks that trade in Libor, which is mostly European banks, don't trust each other," he said. "They don't that the banks on the other side of the transaction have the balance sheet to repay the loan."
And that's just a small indication of what Marta sees as a more prevalent breakdown in trust within the global financial system now that "the real money investor on the back end of the intermediation pipeline" has woken up to how unreliable the credit ratings on securitized bonds are, Marta added.
Battipaglia at Stifel Nicolaus predicts the financial companies will continue to take writedowns against impaired bond positions and busted collateralized debt obligations, to be followed by busted corporate loan obligations. The economy may well fall into a recession in 2008 that could be deeper and longer than anticipated. If so, that would spook the stock market, which has forecast an 8% to 10% gain in the S&P 500 index next year, he added.
In economic news Wednesday, the U.S. trade deficit widened to $57.8 billion in October, slightly above the anticipated level of $57.1 billion. U.S. import prices jumped 2.7% in November, more than expected, while export prices were up 0.9%.
January NYMEX crude oil jumped $4.09 to $94.35 per barrel on speculation that the Fed's plan to provide cash to banks will rekindle economic growth and increase demand for fuel. The U.S. Energy Information Administration released data showing gains of 700,000 barrels in U.S. crude inventories and 1.6 million barrels in gasoline stockpiles, while distillate stockpiles dropped by 800,000 barrels.
Among the stocks in the news Wednesday, Bank of America said it expects to take loan loss provisions of about $3.3 billion in the fourth quarter, reflecting increased reserves of roughly $1.3 billion. One-third of the increase is due to growth in its consumer lending portfolios, but the remaining two-thirds stems from deterioration in consumer real estate and small business. Based on current conditions, BofA expects recently forecast sizeable writedowns particularly in CDOs to be larger than already reported, but won't know until the end of the fourth quarter. Merrill Lynch downgraded the stock to neutral from buy. BofA shares ended 2.7% lower Wednesday.
Wachovia said it now sees a loan loss provision of about $1 billion in excess of charge-offs in the fourth quarter, nearly double its original estimate of $500 million to $600 million in excess of charge-offs. Shares fell 3.4%.
Citigroup shares fell 5.3% after Morgan Stanley advised investors to sell them short. CIBC World Markets reiterated its sector underperform rating on the stock, calling the tone of the conference call with new CEO Vikram Pandit "defensive" and saying the bank will be even more under-capitalized when it reports fourth-quarter results than it is now.
SLM (SLM) shares fell 10.8% after it said it expects core profits in the fourth quarter to be between 52 and 57 cents a share, excluding non-recurring items such as merger-related costs, hit by funding costs and higher reserves for its Federal Family Education Loan Program (FFELP) portfolio. The largest U.S. private source of funding and service support for higher education loans lowered its 2008 core earnings forecast from $3.25 to $2.60 to $2.80 a share, due mostly to higher costs from replacing the company's interim funding facility. It also said the J.C. Flowers Group has said it no longer wants to pursue an acquisition of SLM.
Office Depot (ODP) shares dropped 11.5% after it said that weakness in housing-related economic conditions in key markets such as Florida and California that hurt third-quarter results appears to be spreading to other U.S. retail markets, creating more pressure on sales and margins. The company also said that since inventory purchases are down due to lower sales and disciplined inventory management, fourth-quarter vendor program support levels are now expected to be about $70 million lower than last year.
European stocks were trading higher Wednesday. In London, the FTSE 100 index pulled back from highs to trade 0.35% higher at 6,559.80. In Paris, the CAC 40 index climbed 0.32% to 5,743.32. Germany's DAX index bounced 0.83% to trade at 8,076.12.
Major Asian markets finished lower. Japan's Nikkei 225 index slid 0.70% to 15,932.26. In Hong Kong, the Hang Seng index dropped 2.41% to 28,521.06. The Shanghai composite index lost 1.54% to trade at 5,095.54.
Treasuries closed lower in price Wednesday on news of plans by central banks on both sides of the Atlantic to provide liquidity in order to avoid a situation in which banks grow less willing to lend due to credit concerns. Bonds recovered from their worst intraday levels, however, pacing a downturn in equities from opening gains.
The 10-year note slid 22/32 to 101-20/32 for a yield of 4.05%, while the 30-year bond tumbled 24/32 to 107-00/32 for a yield of 4.51%.