MarketView for January 28

Summary

Stock prices rallied sharply on Wednesday; over optimism the Obama administration was making progress on a plan to relieve banks of money-losing assets. Adding to the upward momentum for a short period of time was the Federal Reserve's statement that it is prepared to buy long-term government debt, but that momentum gave way when investors began to realize that the Fed's purchases won't be made any time soon.

Following its two-day policy meeting, the the central bank's policy-setting committee signaled in its statement some concern that deflation risks were rising  and that it was holding its fed funds target range for overnight interest rates at zero to 0.25 percent and repeated that it thought rates could stay unusually low for some time.

Financial stocks were among the day’s best gainers, with JPMorgan pushing the Dow Jones industrial index higher as it gained 10.4 percent. Bank of America ended the day nearly 14 percent higher, while Citigroup was up more than 18 percent. JPMorgan ended the day at $27.66, while Bank of America finished at $7.39.

There were rumors circulating through Wall Street all day that there were plans afoot to create a "bad bank" that would mop up assets whose worth has plummeted, and in turn help revive lending to consumers and businesses. Adding to the building confidence was word that Sheila Bair, the chairman of the Federal Deposit Insurance Corp, is floating the idea that the FDIC could manage the "bad bank.

Worries concerning the health of the financial sector have been fueling the uncertainty over the performance of stocks' throughout January, which is traditionally seen as a guide to the year's prospects.

Technology shares rose sharply, led by such bellwethers as Apple, up 3.8 percent at $94.20. IBM was the Dow's top advancer, finishing up 3.5 percent at $94.82. Yahoo was up 8 percent to $12.24 after it posted quarterly results late on Tuesday that exceeded expectations.

Price of Crude Oil Rises

Oil prices were higher on Wednesday after the Energy Information Administration showed a 1-million-barrel draw in distillate stocks last week as cold weather hit the Northeast, along with a surprise 100,000 barrel drop in gasoline supplies. In addition, OPEC vowed to fully implement its steep supply cuts by the end of the month.

OPEC Secretary General Abdullah al-Badri said at the World Economic Forum in Davos, Switzerland, that even an oil price of $50 a barrel was too low to encourage investment in new supply and added that the cartel would fully enforce supply curbs by the end of this month.

OPEC has agreed to shave some 4.2 million barrels per day of production since September to counter the free-fall in oil prices from record peaks over $147 in July.

Domestic sweet crude futures for March delivery settled up 58 cents per barrel at $42.16. London Brent settled up $1.17 per barrel at $44.90. Crude stocks rose sharply, however, up 6.2 million barrels, as refiners facing weak fuel demand slowed operations. Crude stocks are up more than 44 million barrels in the past four months, the biggest four-month increase since 1990, according to EIA data, as refiners put oil in storage instead of into processing units.

Fed Prepared to Buy Long-Term Debt

The Federal Reserve on Wednesday said it is prepared to buy long-term government debt if that would help improve credit conditions and signaled some concern that deflation risks were rising. In a statement issued at the end of a two-day meeting, the central bank's policy-setting committee also said it was holding its target range for overnight interest rates at zero to 0.25 percent, the level reached in December, and repeated that it thought rates could stay unusually low for some time.

"The committee ... is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets," it said. In December, the Fed had said only that it was studying that option.

The committee voted 8-1 in support of the decision. Richmond Federal Reserve Bank President Jeffrey Lacker dissented, saying he thought the Fed should immediately move to a program to purchase government bonds. As a result, government debt prices fell sharply, suggesting that the markets wanted a clearer sign the Fed would become a buyer of bonds.

With benchmark overnight rates virtually at zero, the Fed has turned its focus to what Chairman Ben Bernanke has dubbed a "credit easing" approach that targets specific assets and markets in the hope of restoring normal lending. The central bank is endeavoring to ensure a year-long recession does not lead to a prolonged period of falling prices that could further undermine activity.

"The committee continues to anticipate that a gradual recovery in economic activity will begin later this year, but the downside risks to that outlook are significant," it said.

It added that it "sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term".

The Fed said that if needed it would expand an existing program in which it is buying large quantities of mortgage-related debt, and reiterated that it was about to launch another program to shore up auto, credit card and small business lending.

Administration Looking To Establish a “Bad Bank”

The Obama administration is increasingly focused on the possible creation of a "bad bank" that would let financial institutions move toxic assets off their books, an idea that cheered Wall Street and helped push financial shares higher on Wednesday.

Sheila Bair, chairman of the Federal Deposit Insurance Corp, has let it be known that her agency should manage such a bad bank. Bair contends the FDIC is best positioned to run such a government entity because it has years of experience disposing of the least-valuable assets of failed American banks.

"Sheila Bair seems to be offering her agency as a logical manager of this plan because it is the FDIC's traditional role and it is their expertise," John Dearie, executive vice president at the Financial Services Forum who previously held various roles at the New York Federal Reserve was quoted as saying.

"Any sort of credible plan for dealing in a definitive way with these toxic assets is music to the ears of equity investors," Dearie said.

Financial stocks traded higher on optimism that President Barack Obama and his administration will swiftly act to stabilize the ailing banking sector.

Laura Tyson, who was an economic adviser to President Barack Obama's election campaign, fueled speculation on Wednesday that the creation of a bad bank is near. Tyson said that repairing financial markets and revitalizing lending will require governments to remove bad assets from banks and recapitalize them.

"The natural next step is, which is real simple, you take the bad assets out, the balance sheets are hit really hard, you recapitalize banks with different rules, and they go out again and lend," Tyson said in a panel discussion at the annual meeting of the World Economic Forum in Davos, Switzerland.

For weeks top U.S. policymakers have been discussing the idea of a bad bank, also known as an aggregator bank. The Obama administration had hoped to reveal a comprehensive plan by the end of this week to stabilize the financial system.

Treasury Secretary Timothy Geithner said on Wednesday that the administration is "looking at a range of options" to repair the financial system and that its decisions could be made public "relatively soon." Geithner said last week that the new administration was reviewing the option of setting up a bad bank, but that it is "enormously complicated to get right."

Nonperforming loans on U.S. banks' balance sheets are seen as a key reason why banks are reluctant to resume lending. The lack of credit has contributed to a year-long recession sparked by the collapse of the housing market.

A series of government efforts to clean up the mess have fallen short, as evidenced by banks such as Citigroup and Bank of America coming back to the government for more money, in return for partial public ownership.

Congress has yet to see details of how a bad bank option would be carried out, indicating the White House is still formulating its plan and working out the details.

Dearie, of the Financial Services Forum, said the valuation issue is just one outstanding question. Others include how the bad bank would be financed, who would run the government facility, and what would be the ripple effect on the banking industry.