Fed discount window mixed blessing for Lehman

WASHINGTON (Reuters) - The Federal Reserve's new credit facility for Wall Street firms substantially reduces the chances that investment bank Lehman Brothers, or any similar institution, would face the same crisis of confidence that brought down Bear Stearns in March.

On Monday Lehman LEH.N projected a $2.8 billion loss for its second quarter and raised $6 billion in fresh capital, but the investment bank was quick to deny it needed to borrow under the Fed's new lending program, suggesting limits to the facility's usefulness as a safety valve for the financial system.

Commercial banks that have long had access to emergency Fed loans have often been hesitant to approach the central bank out of fear their borrowing would become known and that they would be tarred for being in distress.

When global credit markets began to seize up last summer, the Fed openly encouraged eligible banks to borrow at its discount window and it has had success reducing the stigma of emergency borrowing for commercial banks.

However, investment banks still appear reluctant to tap their new-found ability to borrow from the Fed.

"The discount window (for primary dealers) to some extent now has the stigma issue associated with it," said Torsten Slok, an economist for Deutsche Bank.

Concerns about Lehman's financial health rattled financial markets last week, offering a reminder that the credit crisis that burst into view last August has yet to fully run its course.

The storm in financial markets reached a crescendo in March this year when the Fed stepped in to broker the sale of Bear Stearns, which stood on the brink of bankruptcy.

Last week, Lehman shares tumbled on rumors the firm had borrowed directly from the Fed, but Lehman denied it had done so. It said it had tapped the central bank's credit line on April 16, but for testing purposes only and not because it really needed funds.

Concerns over the firm's health remain, however, and its stock was down over 6.0 percent in mid-morning trade on Wednesday.

SAFETY NET

The availability of an emergency facility for primary dealers, which the Fed launched in March to match the traditional discount window for deposit-taking banks, should help avoid any repeat of the type of bank run Bear Stearns experienced.

"The fact that the primary dealer credit facility is there does probably limit the likelihood that we see a rushed weekend transaction take place," said Julia Coronado, a former Fed staffer now with Barclays Capital.

"Even if the Fed became uncomfortable with solvency, it would have more time to come up with a negotiated solution," she said.

In recent months, the Fed has unveiled an array of new programs to ensure that both depository banks and investment banks have access to funds after market participants pulled back from lending against all but the safest collateral in the wake of the U.S. subprime mortgage market collapse last year.

The Bear Stearns crisis focused attention on the importance of the role of primary dealers, large financial institutions that trade Treasury debt directly with the Fed.

The central bank launched a primary dealer credit facility to help those institutions if they were having difficulty securing funds in the market.

FED'S DISCRETION

Firms can borrow at the window against a broad range of collateral that includes mortgage-backed and asset-backed securities. Borrowers can borrow up to the amount of the eligible collateral they post, and institutions that make frequent use of the facility are charged additional fees.

At any point, though, the Fed could decide that lending to an individual firm was too risky.

"All discount lending must be to the satisfaction of the Federal Reserve," said former Fed monetary affairs director Vincent Reinhart, now with the American Enterprise Institute.

"So, a run against a dealer could lead it to exhaust its funding either if it ran out of collateral eligible for the window or the reserve bank's risk-control procedure imposed a ceiling on borrowing," he said.

While concern about U.S. banks has eased since March, it remains at heightened levels, as measured by risk premiums charged in credit default swaps that reflect market assessments of the chance of default at given financial institutions.

Fed officials are already discussing whether to wean Wall Street from credit facilities aimed at easing market strains or to demand new authority over investment banks to counter-balance access to Fed funding.

Some officials worry markets will be emboldened by the government safety net to take excessive risks.

"The more extensive the access, the greater the degree to which market discipline will be loosened and prudential regulation will need to be tightened," Fed Vice Chairman Donald Kohn said last month.

Borrowing at the Fed's discount window has been heavy, a sign that the Fed's safety net continues to help markets regain their footing, according to some analysts.

In the meantime, though, the contained squall surrounding Lehman points to a stabilizing role played by the primary dealer facility as institutions write down losses and repair their balance sheets.

"If there is uncertainty and nervousness about a heightened risk of some bank getting in trouble, then we still have a probability of systemic risks in the financial system, and that's something the Fed doesn't like at all," Deutsche Bank's Slok said.

(Reporting by Mark Felsenthal)