FEARS about the state of the world economy increased dramatically after the US central bank had to rescue one of the world's biggest and best-known investment banks.
The 80-year old Bear Stearns bank will probably have to be sold and broken up after other banks stopped dealing with it for fear the New York-based bank would run out of cash. The investment bank's closure of two of its hedge funds last July sparked the present credit crisis.
The Federal Reserve announced that it would provide whatever emergency funding Bear Stearns could afford to borrow.
In a statement approved unanimously by its board, the Fed said it "will continue to provide liquidity as necessary to promote the orderly financing of the financial system".
An investment bank would not normally qualify for such funding, which will have to be channelled through another bank, JP Morgan. It is believed to be the first time such a scheme has been used since the Great Depression of the 1930s.
Earlier this week, the Federal Reserve, aware of the growing problems in the US system, said it would make $200bn (€128bn) available to banks which were finding it difficult to conduct their normal business. Leading banks and securities firms have posted $195bn (€125bn) in asset writedowns and credit losses since the beginning of 2007.
The former head of the body which usually defines when the US economy is in recession, said yesterday that there already was a recession and it could be "substantially more severe" than previous ones.
"The situation is bad, the situation is getting worse, and the risks are that it could get very bad," Martin Feldstein, former president of the National Bureau of Economic Research said.
As well as providing billions of dollars in cash, the Fed is slashing interest rates to try to prevent the banking crisis turning into a lending slump which would derail the economy on which much of the rest of the world depends.
"Lower interest rates would not have the same impact in the current downturn, in terms of reviving economic activity, because of the problems in the banking system,'' Professor Feldstein said.
If banks are short of capital, they will lend less for business expansion, personal spending and property purchases, which would cut economic growth.
Bear Stearns, as an investment bank, does not have small depositors like Northern Rock. But its connections with the rest of the financial system mean it could not be allowed to fail, observers said.
"These investment banks need capital and borrowing to run their business. Without the confidence of their trading partners, they come to a screeching halt," said analyst Bob McDowell at the research Tower Group in New York.
In an example of "contagion", Bear's problems were being linked to the failure of the mortgage funds in Carlyle Group, a conglomerate linked to President George W Bush's family.
Market rumours said Bear Stearns would have to take over some of Carlyle's mortgage products, and would be unable to sell them on. This meant other banks were unwilling to take the perceived risk of lending to Bear.
The bears bring down Bear: Page 35