A surprise rate cut by the Federal Reserves Open Market Committee on Wednesday has renewed optimism that credit quality is on the mend.
The largest U.S. banking companies, many of which have warned of loan losses and rising nonperforming assets in recent months, stand to gain the most, economists said, because their smaller, below-investment-grade borrowers will have more breathing room.
The Fed lowered the federal funds rate by 0.5%, to 6%, and the discount rate by 0.25%, to 5.75%. The Fed also said it would approve a further 0.25% cut of the discount rate on the requests of the Federal Reserve Banks.
Markets bounced on the move. The American Banker index of top 225 bank stocks hit an all-time high, 1,005, up 8.28%. The index of 50 bank stocks was up 5.54%. The Nasdaq composite index soared 14%, the Dow 2.81%, and the Standard & Poors 500 index jumped 5%.
Mark Vitner, a senior economist at First Union Corp. in Charlotte, N.C., said, The biggest beneficiaries will be the money-center banks. Their loan portfolios have shown deteriorating quality, and this move should shore up the shakier borrowers.
The move could also be a boost to capital markets activities, which slowed markedly in the last weeks of 2000 and are seen as a drag on fourth-quarter profits at many commercial banks and Wall Street firms. The cut could particularly renew interest in the high-yield market, which all but evaporated in November and December.
More liquidity should help high-yield borrowers, said Lori Appelbaum, a bank analyst at Goldman, Sachs & Co.
But other businesses may not show any changes. Larry Spera, senior vice president of capital markets for MortgageIT.com Inc., said the Feds move would have little short-term impact on the mortgage market, where rates have already bottomed out in anticipation of an easing. He said he expects mortgage rates to stabilize.
I anticipate settling around a 7% level for the near term, he said. Were definitely in a refinance pattern and well stay there for the beginning of 2001.
Still, there is a possible downside to a rate cut on profits at the biggest adjustable-rate mortgage lenders: the risk that people will refinance their adjustable rate mortgages with lower, fixed-rate loans, said Howard Shapiro, a thrift analyst at Goldman Sachs Group. Portfolio growth will be more difficult, he said.
Interest rates were widely expected to come down at the next meeting of the FOMC on Jan. 30 and 31, though there had been speculation in recent days that the Fed could act earlier. Nevertheless, the Fed surprised the market by reducing rates by a greater than expected 50 basis points even before Fridays disclosure of employment figures for December.
The Fed cited further weakening of sales and production, and in the context of lower consumer confidence, tight conditions of some segments of financial markets as its reasons for acting. The FOMC stated that it weighed long-term price stability against conditions that may generate economic weakness in the foreseeable future.
Diane Swonk, chief economist at Chicagos Bank One Corp., said that the Fed lowered rates to offset a recession. A clear message was sent here, Ms. Swonk said. This is an insurance policy against recession.
Indeed, Sung Won Sohn, chief economist at Wells Fargo & Co. in San Francisco, said that the odds of a recession or even a hard landing are now diminished. He, like many other economists, said Wednesday that he expects a further easing of 0.25% at the scheduled FOMC meeting at the end of this month.
Mr. Sohn said the Fed had to move now because the market expected a cut later this month. If you give the market what it expects you get a yawn, he said. This will have a much more positive reaction.
Though most economists said they were positive about the cut, some said the benefits would not come immediately. You can expect continued signs of economic weakness and more earnings disappointments, said Mickey Levy, an economist at Banc of America Securities.
And while rate cuts are generally assumed to have a positive effect on bank stocks in general, some say that asset quality issues could prevent bank shares from soaring. Bank stocks would benefit from a better interest rate environment, analysts argued, but investors would continue to watch earnings closely before they put more money into the sector.
Liz Moyer, Laura Mandaro, Robert Julavits, Patrick Reilly, and Matt Ackermann contributed to this report. 
