Fed Widens Collateral for Loans to Investment Banks (Update3)

By Craig Torres and Scott Lanman

Sept. 14 (Bloomberg) -- The Federal Reserve widened the collateral it accepts for emergency loans to securities firms, helping Wall Street weather a Lehman Brothers Holdings Inc. bankruptcy filing.

A group of 10 banks that includes JPMorgan Chase & Co., Goldman Sachs Group Inc. and Citigroup Inc. separately formed a $70 billion fund to ensure market liquidity.

``The steps we are announcing today, along with significant commitments from the private sector, are intended to mitigate the potential risks and disruptions to markets,'' Fed Chairman Ben S. Bernanke said in a statement released in Washington today.

The central bank's action is aimed at assuring Wall Street that short-term funding will be readily available as New York markets open. U.S. stock-index futures slumped 3 percent in Asian trading on concern a Lehman failure will deepen the yearlong credit crisis and worsen the U.S. economy's downturn.

Banks and brokers opened a special over-the-counter derivatives trading session today to consolidate trades with New York-based Lehman. The firm and its lawyers are getting ready to file the documents for bankruptcy protection tonight, a person with direct knowledge of the plans 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. The central bank first set up the program in March in the wake of the collapse of Bear Stearns Cos.

$200 Billion

Collateral for the Term Securities Lending Facility, which auctions loans of Treasuries, will now include all investment- grade debt securities. The size of the TSLF will also increase to $200 billion from $175 billion, the Fed said.

Today's steps may spur speculation the Fed's next move will be to lower its benchmark interest rate, rather than raise it. Expectations of at least a quarter point cut in the 2 percent rate by December soared to 31 percent Sept. 12 from 11 percent a week before.

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.''

Lehman headed for bankruptcy after Barclays and Bank of America abandoned talks to buy the firm. Separately, Merrill Lynch & Co. was in talks to merge with Bank of America Corp. after Merrill, the third-biggest U.S. securities firm fell by more than 35 percent last week. The two companies agreed to a $44 billion merger, a person with knowledge of the deal said.

Liquidity Steps

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.

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 Cos. and the mortgage companies Fannie Mae and Freddie Mac.

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

The Fed said that collateral eligible for loans to securities dealers has been broadened to closely match ``collateral that can be pledged in the tri-party repo systems.''

Repo Market

JPMorgan and Bank of New York Mellon Corp. are the only banks that serve in a trade-clearing capacity in the so-called tri-party repo market. Under the transactions, Wall Street dealers borrow cash from institutional investors in exchange for a range of collateral that safeguards their loan. The two banks stand between the brokers and the investors.

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

``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, referring to all of today's announcements.

$7 Billion Each

The consortium 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. The association may expand to include other banks, it said.

The bank group's fund is reminiscent of the plan Paulson brokered in October 2007 to help revive the asset-backed commercial paper market. In that proposal, banks including Bank of America Corp. would have organized a fund of as much as $80 billion to rescue so-called structured investment vehicles.

The SIV fund was never activated because banks that formed the SIVs decided to take them on to their own balance sheets.

Paulson said that he would engage with regulators and policy makers from abroad and that he was prepared to act as needed to keep markets stable.

``I am committed to working with regulators and policymakers -- including Congress -- to take necessary and appropriate steps to maintain the stability and orderliness of our financial markets,'' the Treasury chief said.

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.netScott Lanman in Washington at slanman@bloomberg.net

Last Updated: September 14, 2008 23:27 EDT