September 15, 2008 / 2:21 AM / 11 years ago

Fed braces markets for likely Lehman collapse

WASHINGTON (Reuters) - The U.S. Federal Reserve on Sunday launched a series of emergency measures to calm financial markets and ease any trading disruptions that could arise from a collapse of investment bank Lehman Brothers.

One of the biggest changes the Fed made was to accept equities as collateral for cash loans at one of its special credit facilities, the first time that the Fed has done so in its nearly 95-year history.

The Fed’s actions and an agreement by 10 of the world’s biggest banks to set up a $70-billion borrowing facility were intended to make sure market participants have ample access to cash while Lehman’s affairs are wound down in markets over coming weeks or months.

Analysts said the Fed was increasingly making itself the lender of last resort for sorely stressed investment banks and seemed fearful the financial system was at risk of a meltdown as problems that originated in the U.S. subprime mortgage sector spread.

“There is little doubt that the Fed believes systemic risk is becoming closer to really landing on shore,” said Tom Sowanick, chief investment officer for Clearbrook Financial LLC in Princeton, New Jersey.

The steps were the latest in a series of aggressive actions from the Fed dating to last August aimed at keeping markets liquid and trading at a time mounting defaults on U.S. mortgage debt were leading banks to recoil from providing credit.

In March, the central bank put up cash to facilitate JPMorgan Chase’s takeover of Bear Stearns, concerned that letting the troubled investment bank collapse could trigger a system-wide crisis.

This time, however, the central bank — in three days of crisis talks at the New York Federal Reserve Bank — declined to put taxpayer funds on the line to prop up Lehman. Instead, it moved aggressively to ensure any unwinding of Lehman’s affairs would be as orderly as possible.

VULNERABLE MARKETS

“In close collaboration with the Treasury and the Securities and Exchange Commission, we have been in ongoing discussions with market participants, including through the weekend, to identify potential market vulnerabilities in the wake of an unwinding of a major financial institution and to consider appropriate official sector and private sector responses,” Fed Chairman Ben Bernanke said in a statement.

“The steps we are announcing today, along with significant commitments from the private sector, are intended to mitigate the potential risks and disruptions to markets,” he added.

In addition to broadening the collateral it would accept from investment banks for direct Fed loans, the central bank said it was increasing the amount of Treasury securities it auctions on a regular basis under one of its lending programs.

Treasury Secretary Henry Paulson, who worked throughout the weekend in New York in the bid to find a suitor for Lehman but who likewise refused to commit government funds to the effort, praised bankers for putting up money in a special fund to provide another source of liquidity as Lehman is shuttered.

“I particularly appreciate the efforts of market participants who came together this weekend and initiated a set of steps to facilitate orderliness and stability in our financial markets as we work through this extraordinary environment,” Paulson said in a statement.

The $70-billion facility arranged by a consortium of 10 banks aims to help foster an “orderly resolution” of derivative exposures between Lehman and its counterparties, the banks said in a statement.

The U.S. Securities and Exchange Commission also pledged its efforts to make sure that customers of Lehman will not suffer in coming weeks. As regulator of the nation’s broker-dealers, the SEC oversees a number of programs that aim to protect customers, including an offer of insurance, and it said it was in touch with global regulators to keep markets orderly.

A HELPING HAND

The most striking new Fed action was its decision to accept equities as collateral for cash loans under its Primary Dealer Credit Facility for investment banks. Until now, collateral was limited to investment-grade debt securities.

“The Fed’s action allows dealers to pledge an asset class that is a significant part of the Street’s securities positions,” said Tony Crescenzi, chief bond market strategist, Miller, Tabak & Co in New York, giving them significantly more access to loans if they need them.

The Fed also said it was increasing the total amount that it offers under a separate program that lends out liquid Treasury securities to $200 billion from $175 billion. It will also begin holding auctions under this program more frequently.

In a third step, it said it will temporarily allow commercial banks to extend liquid funds to their brokerage affiliates for assets that would normally be accepted in tri-party repurchase agreements.

It said this would be permitted only until January 30, 2009, apparently reflecting the Fed’s hope that stressed repo markets would be operating more normally by then.

Additional reporting by David Lawder and Rachelle Younglai

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