Fed holds rates as liquidity freezes

The Federal Reserve kept interest rates unchanged at 2 per cent yesterday in spite of the financial hurricane raging in global markets.
Its decision to hold firm against a rate cut came as financial turmoil unleashed by the failure of Lehman Brothers and fuelled by the crisis at AIG convulsed global markets for a second day yesterday as money markets froze.
Some analysts speculated that the Fed could announce a back-to-back loan to the embattled insurer AIG via a third party bank, such as JP Morgan Chase, as a partial substitute for a rate cut in terms of calming market fear of sudden asset sales by the troubled insurance group.
Brutal conditions in European money markets yesterday morning, saw the overnight dollar borrowing rate briefly hit 10 per cent amid a desperate scramble for liquidity. Financial stocks came under severe strain as sentiment was depressed by AIG's deepening plight, a slump in the shares of HBOS, the UK's largest mortgage lender, and a damaging credit rating downgrade for Washington Mutual, the troubled US bank.
Central banks around the world fought surging demand for cash as banks hoarded reserves and refused to lend to each other, injecting about $230bn in overnight and two day liquidity.
At midday in the US the market appeared to be putting equal odds on a big half-point cut in rates and no rate cut.
The Vix volatility index – a gauge of fear on Wall Street – hit levels only exceeded on a single day during the March Bear Stearns crisis, while repo market liquidity dried up as institutions with Treasuries refused to lend them to other institutions for fear of counterparty risk.
“There is still a lot of fear and turmoil in the financial markets,” said David Viniar, chief financial officer of Goldman Sachs, after his firm reported the biggest drop in profits since its 1999 listing.
Shares in AIG, whose share price has been hammered by fears of a credit downgrade, fell more than 70 per cent before paring losses on hope of a government intervention.
Lehman Brothers, the investment bank that filed for bankruptcy at the weekend, reached an agreement in principle to sell most of its US broker dealer operations to Barclays of the UK.