By Krishna Guha in Washington
Ten of the world’s biggest banks have agreed to pool $70bn in a giant liquidity fund as part of a dramatic series of private and public sector initiatives intended to mitigate the impact of the expected failure of Lehman Brothers, the investment bank.
The moves came as Merrill Lynch, another investment bank, prepared to announce that it was being taken over by Bank of America.
The Federal Reserve said it was dramatically easing its lending terms and would allow investment banks to pledge equities and loans in return for cash.
Both the Fed move and the new private sector liquidity fund are specifically aimed at countering a feared disruption in the triparty repo market, a market in which investment banks secure short-term funding, much of it from money market mutual funds.
The Securities and Exchange Commission issued a statement saying that it would ensure an orderly winding down of Lehman in conjunction with its international counterparts.
Treasury Secretary Hank Paulson said the co-ordinated moves, announced late on Sunday night, would “be critical to facilitating liquid, smooth functioning markets and addressing potential concerns in the credit markets” and praised the financial sector for joining forces with the US authorities to contain market risks.
However, the US authorities believe that even these aggressive moves will only mitigate and not prevent a period of turbulence in the markets that could last for a number of days.
The 10 banks – Bank of America, Barclays, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JP Morgan Chase, Merrill Lynch, Morgan Stanley and UBS – all pledged $70bn towards the liquidity fund, which is in effect a self-insurance scheme.
Each of them will be able to borrow up to one third of the total fund – about $23bn – as needed against a very wide range of collateral, including assets such as real estate that still cannot be pledged in return for loans from the Fed.
In a joint statement, the banks said the fund was intended to support liquidity and reduce volatility in an “extraordinary market environment.” They said they would also work towards an “orderly resolution” of Lehman derivatives exposure.
Ben Bernanke, the Fed chairman, said the Fed was taking a series of steps to “mitigate the potential risks and disruptions to markets” arising from the crisis at Lehman.
The Federal Reserve announced a dramatic easing of the terms under which it lends to primary dealers – most of whom are investment banks – under the Primary Dealer Credit Facility. Dealers will now be able to pledge a wide range of assets including equities, whole loans and sub-investment grade debt.
The Fed – which meets on Tuesday to set interest rates – also announced that it was broadening the range of assets that can be pledged in exchange for loans of government bonds under its Treasury Securities Lending Facility to include all investment-grade debt, increasing the size of this scheme from $175bn to $200bn and increasing the frequency of its auctions.
The Fed added that it was suspending a rule that normally prohibits deposit-taking banks from using deposits to help finance their investment banking subsidiaries to allow them to fund activities normally funded in the repo market on a temporary basis until January 30 2009.
The Federal Reserve declined to comment on reports that AIG, the troubled insurance company, was seeking the ability to borrow from it as well.
The Fed has not at this point acceded to any request from AIG. If there was to be funding for AIG it would probably take the form of an emergency loan rather than a new facility for all insurance companies.
The new Fed terms are much easier than existing ones. The PDCF is now an almost perfect substitute for the triparty repo market – the market in which investment banks traditionally meet much of their short-term funding needs.
Until now an investment bank that faced a sudden cut-off in funding in the repo market would have found it difficult to replace this with Fed cash using the same assets as collateral.
This should allow Lehman to migrate from funding its operations in the repo market to funding its remaining activities with the Fed in a gradual and orderly fashion as its activities are unwound.
However, other investment banks remain extremely reluctant to borrow from this facility, fearing it would be seen as a sign of desperation.
This “stigma” problem with the PDCF explains why the Fed had to expand and ease the terms on its Treasuries lending facility as well – as the latter is widely used by all investment banks.
The US authorities have put intense pressure on a number of weak financial institutions to strengthen their financial positions, if necessary by takeover by stronger entities.