Wall Street woes force U.S. to seek cash for Fed

WASHINGTON/LONDON (Reuters) - The U.S. government on Wednesday sought to raise $40 billion in a bid to boost the Federal Reserve's financial firepower to fight a crisis of confidence that has rocked Wall Street and beyond.

Other central banks also battled to restore confidence in financial markets as share prices gave up brief gains made on news of the U.S. government bailout of crippled insurer AIG and the cost of short-term borrowing remained high in interbank markets.

The U.S. Treasury Department said it was selling $40 billion of cash management bills -- effectively new debt -- at the request of the Federal Reserve to help the central bank "better manage their balance sheet," a Treasury statement said.

Separately, the Treasury said it would auction on Thursday $60 billion of cash management bills in two equal tranches of 20- and 76-day maturities.

The Treasury's announcement of a new "supplementary financing program" came hours after the Fed offered up to $85 billion in loans to rescue American International Group -- a move that gives the Fed a near 80 percent stake in the company.

Analysts expressed concern that more debt was being placed on the government's balance sheet.

"This indeed amounts to turning on the printing presses to make money," said Sung Won Sohn, an economics professor at California State University, Channel Islands.

Asian central banks plowed extra liquidity into short-term funding markets, though many central banks in Europe took their foot off the pedal amid signs of a respite from the sharp surges in short-term borrowing costs in the past two days.

The Bank of England said it would allow banks an extra three months to swap risky assets for government paper, extending a scheme that was set to close next month because of the latest turmoil in financial markets.

Wall Street dealers scrambled for the Treasuries offered by the Fed in three auctions on Wednesday, submitting record bids to borrow $35 billion of Treasury issues for 28 days from the Fed's Term Securities Lending Facility.

Dominique Strauss-Kahn, head of the International Monetary Fund, said there could well be more trouble in what former U.S. Treasury Secretary Robert Rubin dubbed "the worst crisis since the 1930s."

"The consequences for some financial institutions are still in front of us," Strauss-Kahn told reporters in Saudi Arabia.

Investors appeared to agree with that analysis.

CONFIDENCE BLEEDS

Financial markets hemorrhaged confidence through the U.S. trading day, with a positive open for stocks -- after a relief rally in Asia and Europe in the wake of Tuesday's late-night AIG deal -- transformed into a three-year low Wall Street close, as the three major indexes shed more than 4 percent.

The broad S&P 500 index fell 4.7 percent, with financial shares particularly hard hit. Shares of the two remaining independent U.S. investment banks -- Morgan Stanley and Goldman Sachs -- fell sharply.

U.S. Treasuries rallied and bill rates plummeted as unrelenting financial market upheaval fed demand for cash and ultra-low-risk investments while the dollar fell against both the euro and the Japanese yen.

Meanwhile, financial institutions' distrust and fear of lending to each other deepened as the cost of borrowing three-month dollars jumped 18 basis points -- the biggest daily gain in almost nine years -- reflecting high stress in money markets.

"Counterparty risk remains the chief preoccupation for all intermediaries," said Ciaran O'Hagan, strategist at Societe Generale in Paris. "Tensions remain very, very high. There's no reason for (interbank) rates to fall."

"BREAKING THE BUCK"

Reserve Primary Fund, a U.S. money market mutual fund whose assets have tumbled 65 percent in recent weeks, fell below $1 a share in net asset value on Tuesday -- "breaking the buck" in industry parlance. It cited losses on debt issued by investment bank Lehman Brothers Holdings, which filed for bankruptcy on Monday.

"When the $1 value of money funds is questioned, that's as scary as it gets," said David Riley, director of portfolio strategist at Rydex Investments at Rockville, Maryland.

By rough estimate, the various bailouts and loan pledges so far tally more than $900 billion.

German Chancellor Angela Merkel joined a lengthening list of political leaders expressing the belief -- or hope -- that Europe would be spared some of the economic pain that is likely to follow the troubles of big financial institutions.

"The effects until now on the real economy in Germany have been moderate," she told parliament. "However, an open economy like Germany's will not be able to escape completely unscathed."

In Britain, Lloyds TSB has agreed to buy rival bank HBOS Plc to create a 28 billion pound ($50 billion) mortgage company, a person familiar with the matter said on Wednesday, making it the latest troubled bank to be forced into the arms of a better-funded rival.

News of the talks surfaced after shares in HBOS, Britain's biggest home mortgage lender, were battered for a sixth consecutive day due to fears about its funding position.

Japan, Australia and India pumped $33 billion into money markets on Wednesday. Across Asia, which has so far been largely shielded from the worst of the credit crisis, central banks were bracing for more market turmoil.

The Bank of Japan pumped 3 trillion yen ($28.58 billion) into the market in two moves, matching a record from March 31, after overnight rates jumped above 0.7 percent, 20 basis points higher than the central bank's target rate.

Bank of Korea Governor Lee Seong-tae said the credit crisis triggered by U.S. mortgage defaults would drag on and hurt the global economy: "We need to prepare for potential foreign fund outflow from the bond markets in the medium term."

Seoul has spent more than $30 billion this year to support the won, which has lost 17 percent against the dollar so far this year.

Russia looked particularly fragile as Moscow stocks plumbed new lows in the worst decline in at least a decade and the central bank injected a record 340 billion rubles of one-day funds in a Wednesday repo auction.

Trading on Russia's MICEX and RTS exchanges was suspended after their indexes tumbled 10 percent and 6 percent on the day, respectively, reversing earlier gains and marking the biggest percentage fall for the MICEX index since the Russian financial system collapsed in 1998.

Latin American stocks were beaten down to their lowest level in more than a year, with risk assets in Mexico, Brazil, Chile and Argentina all falling.

Brazil's finance minister said the government was ready and willing to provide financing for investment projects in the country if the crisis in global credit markets persists. Chile's central bank president said the country was not immune to global financial turmoil, but was well prepared to face it.

(Writing by Brian Love, with additional reporting by correspondents across Asia, Europe, Middle East and North America, editing by Nick Edwards, Swaha Pattanaik, Gary Crosse and Dan Grebler)