Commentary by John M. Berry
Sept. 16 (Bloomberg) -- Whatever it takes, the Federal Reserve will act to protect the U.S. financial system, and by extension that of the world.
That might include a cut in the Fed's 2 percent target for the overnight interest rate at today's Federal Open Market Committee meeting. If so, the reduction should be a half percentage point to emphasize the central bank's commitment to help financial markets weather the greatest crisis since the Depression.
Fed officials were deeply involved in the urgent weekend meetings at the New York Federal Reserve Bank that culminated in the decision by Lehman Brothers Holdings Inc. to seek bankruptcy protection and Bank of America Corp.'s acquisition of Merrill Lynch & Co.
Yesterday's upheaval in markets was so severe that the Fed had to inject $50 billion in the banking system just to keep overnight rates close to the 2 percent.
On Sept. 12, investors weren't expecting any change in the lending rate target. As a result of the Lehman bankruptcy and the possibility of more to come, fed funds futures contracts showed investors put the probability of a quarter-point cut at 78 percent.
In an effort to help other institutions under pressure, the Fed once again expanded its facilities for direct lending to them. It relaxed restrictions on the type of collateral that can be used to secure Fed loans to so-called primary dealers -- the institutions eligible to deal with the Fed in its daily money market interventions.
Separately, the Fed also eased restrictions of collateral for the loans of Treasury securities under its Term Securities Lending Facility. Auctions of loans will now be held every week instead of every other week, and the total offered will be $150 billion worth of securities rather than $125 billion.
Standing Ready
The Fed said in a Sept. 14 statement that these changes represent a ``significant broadening'' of the types of collateral that will help support ``the liquidity of primary dealers and financial markets generally.''
These are just two more incremental steps the Fed has taken since the crisis began to make much-needed credit available to help stabilize the markets. Until this spring, investment banks had never been eligible to borrow directly from the Fed. That changed with the collapse of Bear Stearns Cos., when the Fed agreed to accept $29 billion worth of less-desirable assets to help JPMorgan Chase & Co. take over the failing securities firm.
Banks used to shun borrowing at the discount window because it was seen as a sign of weakness. Now it's routine, and as of Sept. 10 investment banks and other financial institutions had borrowed a record $23.5 billion from the dozen regional Fed banks.
The Fed's discount rate is set at 25 basis points over the lending-rate target, and any reduction in the target would be matched by a drop in the discount rate.
Preventing Meltdown
What might the Fed do next? Whatever is needed to prevent a market meltdown.
In Lehman's case, Fed and Treasury officials refused to put taxpayer money at risk as they did with Bear Stearns. They were wary of political backlash from that bailout, and this time it just wasn't needed.
A bankruptcy proceeding is usually a long process, one not well suited to prevent a potential financial system failure if, as Bear Stearns did, an institution with many interconnections with other companies runs out of money. The concern is that the initial failure would bring down other institutions.
Partly as a result of Lehman's ability to borrow from the Fed, its problem wasn't a shortage of liquidity but a steady stream of large losses and an inability to raise more capital at a time when the value of its stock was vanishing.
No Federal Money
Officials must have concluded that Lehman could be liquidated in an orderly fashion and that its bankruptcy would not pose a systemic risk. Given the adamant refusal of Treasury Secretary Henry Paulson to put federal money into a deal to rescue Lehman, there was no alternative.
Unwinding the thousands, if not millions of derivatives and other Lehman deals outstanding is going to be a mammoth undertaking. In some previous situations, such as the bankruptcy years ago of Drexel Burnham Lambert, counterparties had wildly different views of the value of their positions.
So there is still considerable risk something will come unstuck. If it does, and the problem is big enough, the Fed and the Treasury might find themselves on the hook.
Meanwhile there's another risk.
Lehman's sale of its assets might depress the value of similar assets held by other institutions, triggering another round of writedowns. Yesterday the Fed asked JPMorgan Chase and Goldman Sachs Group Inc. to lend about $70 billion to one such company, American International Group Inc., the largest U.S. insurer by assets.
Reluctant Cutters
One question the FOMC will have to weigh at today's meeting is how much this latest turmoil may curtail the availability of credit and damage the economy. Some committee members have been reluctant to reduce the lending rate target because inflation has been far higher than they want it to be.
Concern that financial market problems may hurt the weakened economy sent commodity prices tumbling yesterday. Oil prices fell below $100 a barrel and gasoline prices were down sharply as well.
The turmoil, the risk to the outlook and the easing of inflation pressures together make a strong argument for a half- point rate cut.
(John M. Berry is a Bloomberg News columnist. The opinions expressed are his own.)
To contact the writer of this column: John M. Berry in Washington at jberry5@bloomberg.net
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