McClatchy Washington Bureau

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WASHINGTON — The largest Federal Reserve System intervention in the banking system since the 9-11 terrorist attacks halted a sure skid Friday on Wall Street. But jitters reigned as central banks across the globe moved to ensure that the world's financial system doesn't freeze up.

The Fed injected new money for the banking system three times, for a total of $38 billion. Adding to the intrigue surrounding the unusual move, the Fed allowed banks that were seeking to borrow this money temporarily to use mortgage-backed securities as collateral.

These securities are a main cause of the current gyrations on Wall Street as wary investors try to shed them but are finding few buyers. By accepting the securities as collateral, the Fed tried to show that it thought they were reliable investment instruments.

"Today's Fed moves were designed to both add liquidity and boost confidence in the area where it is needed most," Mark Vitner, senior economist for Charlotte, N.C.-based Wachovia Economics Group, said Friday in a late-afternoon note to investors.

Friday action's by the Fed followed similar moves by the European Central Bank and the Bank of Japan, which pumped another $91 billion into their systems. The Fed will watch markets in Asia and London closely over the weekend for signs whether more intervention is needed at home Monday.

The Dow ended the day down just over 31 points.

Economists and financial analysts said Friday that the chances the Fed would be forced to drop overall interest rates had grown sharply. One indicator, the Chicago Board of Trade's futures market, puts the odds of a cut in the benchmark federal funds rate at 82 percent. The Fed's Open Market Committee, which sets rates, is scheduled to meet Sept. 18.

When the Fed moved in 2001, it pumped $100 billion in new funds into the banking system. In a statement Friday, the Fed said it "will provide reserves as necessary" and reminded depositors that it remains the lender of last resort if "unusual funding needs" arise.

"The Fed is worried that the financial system is going to freeze up . . . what the Fed is trying to do is calm down markets, to say, `There is plenty of liquidity, we're here to help you, don't panic,' " said Nariman Behravesh, chief economist for Global Insight, an economic-forecasting firm in Waltham, Mass.

As trading began Friday, the Fed announced that it was making $19 billion available, a show of symbolism to tell the markets that the Fed was on the job. The move had little immediate impact, however, and with the Dow down about 200 points the Fed provided another $16 billion to ensure that credit — the lifeblood of the banking system — didn't dry up. At 1:50 p.m., the Fed acted again, adding another $3 billion.

The Fed actions didn't end the volatility, as Friday trading was marked by wild mood swings. But the Dow Jones Industrial Index closed down 31.14 points, far more comforting than the 387 points — a 2.8 percent drop — on Thursday.

By making more money available, the Fed is trying to make sure that banks have enough funds to conduct their overnight lending to one another. This is akin to making sure that a business avoids cash-flow problems.

"You don't want banks or other financial institutions to suddenly experience difficulty . . . and you risk a chain reaction," said a former Fed insider who worked at the Federal Reserve when it took similar steps to reassure the financial system. The former official spoke on condition of anonymity out of concern that his comments could influence the market.

Federal Reserve Chairman Ben Bernanke is trying to fend off a credit crunch, in which the banking system seizes up like an engine without oil. Already, important companies who are now perceived as risky find themselves unable to borrow money. The latest case involved giant mortgage-lender Countrywide Financial. It announced Thursday that it couldn't sell $1 billion in home loans in the secondary market and was being forced to hold on to them.

Countrywide's news came after last week's spectacular bankruptcy of American Home Mortgage, a major home lender previously thought to be healthy. And there was a sell-off by investors on investment house Bear Stearns, which had been rumored to have more exposure to troubled mortgage-backed securities than it had disclosed.

The White House repeated Friday that it's watching developments. President Bush talked up the economy earlier in the week, saying that economic fundamentals remain strong.

If the turmoil continues and threatens to spill over into the broader economy, the Fed may be forced to drop its benchmark lending rate.

The federal funds rate — the benchmark for a wide array of consumer and business lending rates — stands at 5.25 percent. It hasn't changed since June 2006. It hit its lowest point in June 2003, when it was 1 percent.

"I think my feeling right now is it is time to cut rates," said David Wyss, chief economist for the rating agency Standard & Poor's. "The first requirement for the Fed is maintenance of orderly markets. And there is a risk to markets getting disorderly. Once that happens, it's not a matter of bailing people out. Once that happens, the Fed loses control."

Bernanke has faced this dilemma for months. The housing market has been in a slow-motion spiral downward. Trying to reverse that through interest rates is a problem, however, because core inflation — the measure the Fed watches most closely — is running at an annual rate of 1.9 percent, barely within Bernanke's stated 2 percent comfort zone.

A career academic and expert on the Great Depression, Bernanke took the helm of the Fed last year without the stature of the two previous long-serving chairmen, Paul Volcker and Alan Greenspan. While he's been widely praised, this turmoil is the first real test of his mettle.

"I think it is," said Alice Rivlin, a former Fed vice chairman, who sees similarities with a 1998 crisis that followed the collapse of investment giant Long-Term Capital Management. Back then, inflation was on the high end and worries about credit availability were spreading. The Fed stepped in with a series of rate cuts to boost investor and consumer confidence.

Higher interest rates keep inflation in check by reducing economic activity. Lowering the federal funds rate — with its wide influences on other lending rates — would spark economic activity, but that also could turn inflation embers into flames.

Bernanke, an inflation hawk, thinks that cutting rates would undermine the Fed's inflation-fighting credentials and credibility.

That's why the Fed's Open Market Committee met Tuesday and issued a plain vanilla statement that recognized that stock markets were gyrating but said nothing about what the Fed might do about it. The statement didn't even hint that the Fed would stand by to help.

The stocks of big investment banks such as Goldman Sachs, Lehman Brothers and others that lend heavily to hedge funds were hit particularly hard in early trading Friday, recovering later in the day. Rumors spread that many hedge funds — which are lightly regulated and control huge pools of investment — were preventing their investors from withdrawing money. That's the equivalent of putting a lock and chain around the exit doors.

At the heart of the uncertainty that's roiling Wall Street are mortgage-backed securities, which essentially are home loans bundled together and sold to investors. The big investment houses were the prime issuers of these mortgage-backed securities, and hedge funds snapped up a lot of them.

The markets are afraid that defaults are growing on both the sub-prime mortgages given to weaker borrowers and better-quality home loans that often were akin to second mortgages. These growing default rates have led to investors to flee anything related to the housing sector, from the stocks of home builders to investment banks to mortgage lenders. Banks of all stripes are increasingly wary of any lending, no matter the level of risk, until the problems on Wall Street are sorted out.

Although the troubles in the sub-prime lending sector have spooked financial markets for months, the worst may lie ahead. Most housing analysts think that there was a period in late 2005 and 2006 when lending standards weakened sharply and large numbers of adjustable-rate and exotic loans were extended to people who had weak credit histories. These adjustable-rate loans are scheduled to reset with much higher interest rates later this year and next year.

Many borrowers took out these loans expecting to refinance before the more onerous terms took effect. But in some markets homes are worth less now than they were when they were purchased two years ago, and banks are in no mood — and in some cases no shape — to refinance the loans.

"It's because everybody expects these resets to be a problem that everyone is selling off now," Wyss said.

The problem is that mortgage-backed securities generally aren't bought and sold like stock but usually are held until maturity, like bonds. Investors are trying to get rid of their holdings in sub-prime mortgage bonds but aren't finding buyers, even at fire-sale prices.

"They're very difficult to dump, because even when markets are good these things don't sell very well" in secondary markets, Wyss said. "These are very illiquid securities even under the best of times."