Lehman fallout threatens deeper, wider recession

By Emily Kaiser - Analysis

WASHINGTON (Reuters) - The fall of Lehman Brothers raises the risk of a deeper U.S. recession that engulfs a broader swath of the global economy as skittish banks around the world lock their vaults.

Countries that had so far escaped the yearlong credit crisis largely unscathed scrambled on Monday to quantify the potential losses after Lehman Brothers Holdings Inc LEH.N filed for bankruptcy.

Banks' borrowing costs soared because of the uncertainty over how far and wide the Lehman impact might extend. If that translates into a crackdown on lending terms for companies and consumers, the economic fallout will be severe.

U.S. growth prospects already looked gloomy even before this weekend's drama, which also included Merrill Lynch MER.N agreeing to be bought by Bank of America (BAC.N) and insurer AIG (AIG.N) looking for financial help.

"At this point, the U.S. will be lucky to escape with a mild recession," said Ken Rogoff, a Harvard University professor and former International Monetary Fund chief economist.

The pain quickly spread to Asia and Europe.

In Taiwan, which had reported little in the way of losses from the subprime mortgage mess, the top financial regulator said Lehman-related exposure for its companies and retail investors totaled $2.5 billion. Two Japanese banks appeared on the list of major Lehman creditors.

In Europe, Germany's Finance Minister Peer Steinbrueck said the initial impact on Germany was limited, but Economy Minister Michael Glos said Lehman's collapse could seriously harm Europe's biggest economy.

"We hope that we don't see a crisis which pushes the global economy to the brink of ruin," Glos said.

Across Europe, banks' funding demands far outstripped the supply offered by central banks, indicating that firms were keeping a tight grip on cash as they assessed the damage.

U.S. interbank interest rates spiked to three times the Federal Reserve's target of 2 percent, and calls grew for additional interest rate cuts.

"This weekend's events raise the probability of one or several major central banks cutting interest rates, possibly as early as this week, and perhaps in a concerted action," Morgan Stanley economist Joachim Fels wrote in a note to clients.

The U.S. central bank's interest rate-setting committee meets on Tuesday, and trading in rate futures markets showed that investors think another reduction is possible then.

DUST SETTLES

Although the financial pain was acute on Monday, Harvard's Rogoff said the Federal Reserve and Treasury Department were right to deny taxpayer money to salvage Lehman Brothers.