Fed May Expand Funding in a `Mother of Year-Ends'

By Craig Torres and Liz Capo McCormick

Sept. 11 (Bloomberg) -- The Federal Reserve may have to increase the cash it provides to banks and brokers, already a record, to help them balance their books at the end of the year.

Six bank failures in the past two months and rising concern about Lehman Brothers Holdings Inc.'s capital levels pushed lenders' borrowing costs to near a four-month high yesterday. They may climb further as companies rush for cash to settle trades and buttress their balance sheets at year-end.

``This could be the mother of year-ends,'' said Brian Sack, vice president of Macroeconomic Advisers LLC in Washington, who used to serve as head of monetary and financial market analysis at the Fed. ``The markets will need extraordinary actions to get through it.''

One option is for banks and brokers to increase the loans they take out directly with the Fed; the central bank reports on the figures today. Officials could also offer options on its biweekly loan auctions or introduce special repurchase agreements to straddle the end of the year, economists said.

Futures traders have also priced in a higher probability of a cut in the benchmark interest rate by at least a quarter-point by year end. Investors now see a 32 percent chance of a cut in December, up from 14 percent a week ago.

Year 2000

When policy makers sought to head off a potential funding crunch with the year 2000 changeover, they auctioned liquidity options to the primary dealers of U.S. Treasuries.

The central bank's latest weekly report on direct loans is scheduled for release at 4:30 p.m. New York time. Lending to commercial banks from the so-called discount window averaged $19 billion in the week through Sept. 3, the fifth record in seven weeks.

Traders in the forward markets, where financial instruments are sold for future delivery, are pricing three-month cash from December to March at 94 basis points over expectations for the federal funds rate. That's up from 85 basis points at the start of the week and an average of 7 basis points in 2006.

``If banks are unwilling to lend to other banks, then they are unwilling to lend to you and me,'' says Stan Jonas, chief executive officer at Axiom Management Partners LLC, a New York investment firm. ``The market anticipates that we will be in a heightened state of credit risk.''

New Tools

As the credit crunch erupted a year ago, Fed officials introduced new tools to stem a jump in borrowing costs. In December, they created the Term Auction Facility to inject cash to commercial banks.

The Term Securities Lending Facility was unveiled in March as a resource for primary dealers of Treasuries, and offers a loan of U.S. government bonds in exchange for collateral including asset-backed debt. After Bear Stearns Cos.'s collapse, the Fed the same month gave dealers access to direct loans.

Acknowledging persistent funding strains, policy makers in July extended the programs through January. They also introduced sales of options on the TSLF to help brokers get through quarter-ends.

``We will continue to review all of our liquidity facilities to determine if they are having their intended effects or require modification,'' Fed Chairman Ben S. Bernanke said Aug. 22.

Solvency Questions

Even if the Fed succeeds in easing the liquidity squeeze, it can do little to alleviate the underlying problem about the solvency of companies that invested in securities whose values are sliding. Worldwide, financial firms have posted $510 billion of writedowns and losses in the crisis, and raised just $359 billion of capital.

``Liquidity tools by definition can only have so much impact,'' said Dino Kos, former head of financial markets at the New York Fed and now a managing director at Portales Partners LLC, a New York research firm.

The Fed ``can alleviate the problem by helping institutions finance these bad assets,'' Kos said. ``But by itself, that doesn't lift the price of these assets. You still have an underlying solvency problem.''

The need for cash is exacerbated by rising credit losses and difficulty in obtaining capital to offset them.

The government seizure of Fannie Mae and Freddie Mac this week may have heightened perceptions of risk in investing in U.S. financial firms. The two companies failed to raise capital even after the Treasury won unlimited powers to inject funds as a backstop in July. After the Sept. 7 takeover, shareholders were nearly wiped out.

``Why would anyone inject equity capital into a financial institution if a few weeks later the government comes in and renders it worthless?'' said Axel Merk, president of Merk Investments, a Palo Alto, California-based fund manager. ``The slope of bailouts is slippery and expensive.''

Falling Stocks

Prices of fixed-rate preferred stock, a security typically used by banks to raise new capital, fell an average of 11 cents to 69.8 cents on the dollar this week, with the biggest drop in a decade Sept. 8, according to Merrill Lynch & Co. index data.

Lehman has lost 72 percent this week, trading at $4.45 at 2:42 p.m. in New York Stock Exchange composite trading. The New York-based investment bank yesterday reported a $3.9 billion third-quarter loss, the biggest in its 158-year history.

Lehman hasn't tapped the Fed for cash since April, a person briefed on the matter said yesterday. Any such loans would appear on the Fed's Primary Dealer Credit Facility figures to be released today; there was no outstanding balance last week.

To contact the reporter on this story: Craig Torres in Washington at ctorres3@bloomberg.net.; Liz Capo McCormick in New York at +1- Emccormick7@bloomberg.net