Fed Expands Lender of Last Resort Role as It Draws Bailout Line

By Scott Lanman
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Sept. 15 (Bloomberg) -- The Federal Reserve may be out of the business of bailing out financial companies; its role as lender of last resort is expanding.

The Fed's handling of the latest crisis on Wall Street signaled that its goal was to prevent Lehman Brothers Holdings Inc.'s bankruptcy from wrecking the entire financial system, and not to rescue any individual firm.

While ``the Fed has to establish its credibility vis-à-vis bailouts,'' central bankers also showed they are prepared to ``do everything in their power to protect the system from a liquidity crisis,'' said New York University economics professor Mark Gertler, who has collaborated on research with Fed Chairman Ben S. Bernanke.

Lehman's bankruptcy contrasted with the support the Fed and Treasury provided for the March buyout of Bear Stearns Cos. and last week's federal takeover of Fannie Mae and Freddie Mac. Instead of committing the government's money to another buyout, the Fed broadened the collateral it would accept for loans to securities firms to ensure that they could continue to trade. In another step to maintain market liquidity, 10 large banks will fund a new $70 billion lending program.

Allowing the failure of a firm like Lehman ``can have cascading effects that will affect liquidity needs of others, so you want to make as adequate provision for that as you can,'' said former Fed Governor Lyle Gramley, now a senior economic adviser for the Stanford Group Co. in Washington.

Changed Conditions

What's changed since the Bear Stearns rescue is the availability of Fed loans to investment banks and the fact that central-bank examiners have begun reviewing the finances of Lehman and other Wall Street firms, oversight they previously did only with commercial banks.

The Board of Governors yesterday approved accepting equities, in addition to investment-grade debt, in the Primary Dealer Credit Facility, the program for lending cash directly to securities firms. The facility was set up six months ago in the wake of Bear Stearns's collapse.

The Fed moves are aimed at keeping markets functioning. Lehman's failure means the primary dealers who trade with the Fed may have to rearrange a complex network of trades, which they depend on to fund their daily activity. If they lose access to cash, even temporarily, the U.S. financial system could grind to a halt.

Wider Collateral

The central bank also decided to accept all investment- grade debt securities as collateral for the Term Securities Lending Facility, which auctions loans of Treasuries. Previously the Fed had excluded debt such as corporate and municipal bonds.

The dealers held $159 billion of corporate bonds as of Sept. 3, according to the New York Fed.

``There is arguably more identifiable value in corporate equities and bonds in terms of future cash flows than there is for many of the mortgage-related assets that were created during the credit bubble,'' said Tony Crescenzi, chief bond market strategist at Miller Tabak & Co. in New York.

The decisions came six weeks after the Fed extended the emergency lending programs through January.

Today's market reaction may influence Fed policy makers as they gather for their regular interest-rate meeting tomorrow in Washington. The chance of a quarter-point reduction in the benchmark overnight lending rate soared to 62 percent from 12 percent, futures trading shows. The rate has been 2 percent since April, when the Fed completed 3.25 percentage points of cuts since last September.

Moral Hazard

Any expansion of the Fed's lender-of-last-resort role entails ``some risk of moral hazard,'' or the fostering of excessive risk taking, Gramley said. ``It's the moral hazard issue that led them to the view that Lehman ought to be allowed to go down the tubes.''

Lehman's failure means ``there will be less chance that deals in the private sector will look to the government for financing, and I think that's a very good thing,'' said former St. Louis Fed President William Poole in an interview with Bloomberg Television.

Even so, Lehman's bankruptcy was followed by calls for the Fed to provide a bridge loan for American International Group Inc., the largest U.S. insurer by assets, whose shares plunged more than 60 percent today as it sought to raise new capital.

Asked about AIG, Treasury Secretary Henry Paulson told reporters at the White House today that ``what is going right now in New York has got nothing to do with any bridge loan from the government.''

``What's going on in New York is a private sector effort, again, focused on dealing with an important issue that's I think important for the financial system to work on,'' Paulson said.

Meeting expanded liquidity needs requires ``establishing a new set of boundaries for central-bank lending,'' Richmond Fed President Jeffrey Lacker said in a June interview. Such limits may not be ``credible unless we let somebody fail in a costly way that is beyond that scope,'' Lacker said.

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net