Fed Widens Collateral, Banks Set Up $70 Billion Fund

By Craig Torres and Liz Capo McCormick

Sept. 15 (Bloomberg) -- The Federal Reserve widened the collateral it accepts for loans to securities firms to include stocks in an effort to help Wall Street weather Lehman Brothers Holdings Inc.'s plans for bankruptcy.

The Fed also yesterday boosted its program for lending Treasuries to bond dealers by $25 billion, bringing it to $200 billion. At the same time, a group of 10 banks that includes JPMorgan Chase & Co., Goldman Sachs Group Inc. and Citigroup Inc. formed a $70 billion fund to ensure market liquidity.

Central bankers and banking leaders acted after three days of emergency talks led by Treasury Secretary Henry Paulson and New York Fed President Timothy Geithner on the mounting turmoil in financial markets. Yesterday's steps may spur speculation the Fed may take further action, including lowering interest rates, to stem a deepening in the yearlong credit crisis.

It is ``critically important to put in a firebreak to an already weakened system,'' said Saumil Parikh, who helps oversee $688 billion at Pacific Investment Management Co. in Newport Beach, California. Policy makers are aiming to prevent a ``broad run on the U.S. financial system,'' he said.


The Fed's announcement came late on a Sunday evening that followed news of Barclays Plc and Bank of America Corp. abandoning talks to buy Lehman, the investment bank that lost 77 percent of its value last week. Bank of America separately agreed to acquire Merrill Lynch & Co. for about $50 billion, according to a statement by the company today.

Bear Stearns Legacy

The easier terms for Fed loans are the latest in an effort by the central bank to ensure liquidity and alleviate a jump in funding costs this year. The program for loans to the primary dealers in Treasuries was set up in March in the aftermath of the collapse of Bear Stearns Cos.

Speculation may climb that the Fed will now consider lowering interest rates further to offset the impact of a tighter credit crunch on the faltering economy. As recently as Aug. 5, the rate-setting Federal Open Market Committee ``generally anticipated'' the next move in rates would be an increase.

Government figures last week showed that retail sales fell in August, a month when the U.S. unemployment rate climbed to 6.1 percent, the highest level in five years.

Liquidity moves ``by the Fed can only go so far,'' said Mark Spindel, chief investment officer at Potomac River Capital LLC, a Washington DC investment firm. ``It just might be that firms and investors might have to take more losses, and maybe what the economy and markets need are lower rates.''

Global Coordination

Fed Chairman Ben S. Bernanke said in yesterday's statement that the Fed has been in touch with other central banks ``to monitor and share conditions in financial markets and firms around the world.''

Talks held at the New York Fed Friday evening, Sept. 12, through late yesterday were aimed at identifying ``potential market vulnerabilities in the wake of an unwinding of a major financial institution.''

Lehman plans to file a Chapter 11 petition in the U.S. Bankruptcy Court for the Southern District of New York, the firm in a statement today. The filing will be by the holding company and won't include any of its subsidiaries, Lehman said.

The Fed will now accept equities in the Primary Dealer Credit Facility, its program for lending cash directly to securities firms, in addition to investment-grade debt. Collateral for the Term Securities Lending Facility, which auctions loans of Treasuries, will now include all investment- grade debt securities.

Cheaper Loans

Fed officials have already made direct loans to commercial banks more attractive this year in an effort to ease funding strains. They lowered the cost to a quarter point more than the benchmark federal funds rate, down from 1 percentage point historically. In March, the so-called discount-window loans were extended to 90 days.

Direct loans to commercial banks hit record levels in six of the past eight weeks, reaching $23.5 billion as of Sept. 10. There were no PDCF loans to the 19 primary Treasuries dealers outstanding.

Paulson and the Fed were against using government funds to prevent Lehman's collapse, seeking to draw a line for bailouts after the rescues of Bear Stearns and the mortgage companies Fannie Mae and Freddie Mac.

The Securities and Exchange Commission separately said yesterday it's ``taking action'' to protect Lehman's customers and will keep staff on-site at the firm ``in coming weeks.''

Changes to the Fed collateral for securities dealers will make it closely match ``collateral that can be pledged in the tri-party repo systems.'' Banks use tri-party repos, or repurchases, for short-term financing amongst each other.

PDCF Backstop

In effect, the Fed is assuring that if investors pull away from brokers, they will be able to access cash through the PDCF with the same wide set of collateral used in tri-party repo, including stocks.

The Fed also granted an exemption on a rule that limits banks' transactions with their brokerage subsidiaries, a move that provides securities dealers with another source of funding if they need it for market making this week.

The group of 10 banks said that any member can borrow up to a third of the fund, to which each is contributing $7 billion. Participants also include Bank of America, Barclays PLC, Citigroup Inc., Credit Suisse, Merrill Lynch, Morgan Stanley and UBS AG.

``These initiatives will be critical to facilitating liquid, smooth functioning markets, and addressing potential concerns in the credit markets,'' Treasury Secretary Henry Paulson said in a separate statement.

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