What Can the Fed Buy to Stop Market and Economic Fear? Buy Bank Stocks

The consensus among economists is that the Federal Reserve has run out of options to save the troubled American economy and collapsed stock markets. That may not be true, depending on how radically the Fed is willing to break from past practices.

The most logical move by the central bank would be to aggressively buy U.S. Treasuries as a sign that the S&P downgrade of U.S. debt is meaningless. Such an action would keep rates down, but they are already near historic lows. That might make the Fed’s actions inconsequential. However, this is only in the short term. Investors who come to grips with the downgrade may decide that other currencies or assets are a better place for capital, particularly if they believe that U.S. deficit growth is out of control. There has already been some sign of that as capital has flowed into Swiss francs and gold.

The other action the Fed could take is to directly buy shares in U.S. banks. These firms sold down by 15% to 20% yesterday. There is a serious question about whether they are free of most legacy mortgage problems. AIG (NYSE: AIG) has sued Bank of America (NYSE: BAC) over the issue of the bank’s sales of mortgage-backed securities. Bank of America committed fraud because it did not disclose risks, according to AIG. The Fed would seem to favor Bank of America if it bought the firm’s stock. This impression would be blunted though if the Fed also bought shares of money center banks and brokerages. The government has already rescued AIG. Perhaps now its can turn its attention to firms that are considered AIG’s temporary enemies.

Bank stocks will probably remain at the heart of the market collapse. Bank of America shares are down 50% this year. That is not nearly as bad as when the credit crisis caused many bank and brokerage stocks to drop more than 80%, but the halving of the market cap of the firm has caused a shudder to run through the market on concerns that Bank of America could be in nearly as much trouble now as it was in 2008.

The first rescue of the bank system was made by Congress and the Administration when they approved the TARP program, mainly after Treasury Secretary Henry Paulson begged for it. Paulson could see that the destruction of American banks could cause a depression. The present situation with the largest U.S. financial firms could turn bleak very quickly if there is a belief that Bank of America does not have the capital to stand on its own. The contagion of that belief would be likely to spread at least as far as Citigroup (NYSE: C).

The Federal Reserve has never been in the business of the purchasing of equities in individual American companies. Perhaps such as action is not even in the central bank’s charter. That does not matter as much as a sign of short-term confidence in large U.S. financial firms does. The Fed could change the market perceptions of companies like Bank of America with just a few days of financial support.

Douglas A. McIntyre