September 13, 2008 / 8:31 PM / 11 years ago

Fed's options limited if Lehman talks fail

WASHINGTON (Reuters) - If intense weekend talks fail to turn up a buyer for investment bank Lehman Brothers, the Federal Reserve’s options for calming markets will be down to words, interest rates, or appeals to Congress to extend its powers.

One option is to do nothing at all and some analysts think that may be the best one, even if it proves to be the straw that breaks Lehman’s burdened back.

“A reasonable argument can be made that a failure, while painful, would not cause systemic damage,” said economist Mark Zandi of Economy.com in West Chester, Pennsylvania. “I think the Fed really can’t do much in this case and probably shouldn’t.”

Since it orchestrated the sale of Bear Stearns to JPMorgan , complete with a $29 billion promise to absorb losses, the U.S. central bank has faced criticism from among its own members and outside that it may have overstepped its bounds.

Letting Lehman fail could help the Fed restore some credibility among those who say its willingness to bail out Wall Street time and again has set a dangerous precedent, one that may be encouraging would-be Lehman buyers to wait and see whether more government cash is coming.

“It would reflect badly on the Fed if they have to bail out Lehman,” said Anil Kashyap, an economics professor at the University of Chicago’s Graduate School of Business.

“It’s been six months since Bear Stearns. Everybody knew that Lehman was shaky. They’ve had six months to think about this and if their best answer is to throw more taxpayer money at them, there is going to be a lot of criticism.”

U.S. Treasury Secretary Henry Paulson let it be known on Friday that he “adamantly” opposed using taxpayer funds to help rescue Lehman and the Fed similarly signaled it didn’t want to do so.

That has persuaded many analysts that Lehman may be the test-case, where officials decide a rescue stands or falls on its own merits and not rely upon guarantees of taxpayer help.

“I think the Fed will seriously consider letting Lehman find a buyer or file for bankruptcy protection,” said Raghuram Rajan, former chief economist at the International Monetary Fund who teaches at University of Chicago’s business school.

“The Fed and the Treasury want to take a stand against the notion they stand behind all large financial firms. Lehman may be where they make the stand.”

WHAT IF?

Since the credit crisis mushroomed in August 2007, the Fed has poured cash into frozen financial markets, created lending facilities to tide over firms in need of emergency funding, and lowered its federal funds rate by 3.25 percentage points.

None of that saved Lehman Brothers from its current predicament. The few remaining measures that are available to the Fed may not be very effective in settling markets either if Lehman cannot find a buyer.

The central bank would undoubtedly offer assurances that it stood ready to provide liquidity to financial markets but that is not the issue afflicting markets.

“We have tons of liquidity, but the problem is that some of the financial pipelines in credit markets are clogged and velocity has slowed down,” said Sung Won Sohn, an economics professor at California State University.

That also argues against an emergency cut in the Fed’s trend-setting federal funds rate, a move Sohn said would be “highly undesirable” since it would incorrectly aim to boost liquidity.

Zandi said that, if the Fed fears systemic risk from a failure of Lehman, then rather than try to boost liquidity federal officials should consider “a big, bold step” to address insolvency such as setting up an institution to help dispose the assets of failed institutions.

The model is the Resolution Trust Corp that was used to help sell assets of failed savings and loans in the 1990s and then was disbanded. Doing so might help break a developing cycle in which investors hold off on bidding because they anticipate that the U.S. government will eventually step in with some form of taxpayer-financed help to close a deal.

The Fed could also go to Congress to ask it to speed up its grant of authority for the central bank to pay interest on reserves it holds for banks. Lawmakers gave the Fed permission in 2006 to pay interest but set 2011 as the effective date.

But again that move would largely be aimed at broadening its powers to provide liquidity to financial markets.

If the Fed had such authority, it could flood the banking system with excess cash without fear the overnight federal funds rate — its main economic policy lever — would plunge in a manner that could set off inflation.

Banks must meet set reserve requirements, but since they receive no interest on those reserves, they have an incentive to lend out any excess cash in the open market, pressuring interest rates lower. If the Fed could pay interest on reserves, it could put a floor under benchmark rates.

Zandi said a more useful immediate move by Fed policymakers, who meet Tuesday to plot interest-rate strategy, would be underline its sensitivity to financial market stress and signal that its next likely interest-rate move will be to lower them, which might bring some calm to markets.

(additional reporting by Tim Ahmann)

Reporting by Glenn Somerville and Emily kaiser

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