Room to Breathe

Room to Breathe

Fed loans may give Lehman Brothers the breathing room that Bear Stearns lacked.

BANKING By Scott Lanman and Steve Matthews / Bloomberg News Service

Access to Federal Reserve loans means Lehman Brothers Holdings Inc., which has plunged this week on concern about its capital, may have breathing room that Bear Stearns Cos. lacked before its abrupt collapse.

The program instituted in the aftermath of the Bear Stearns debacle, the Primary Dealer Credit Facility, could be used for funding while officials, regulators and executives find alternative sources of cash, Fed watchers say.

"The PDCF could be used to keep Lehman operating until a broader solution was found," says Brian Sack, a former Fed research manager who's now senior economist at Macroeconomic Advisers LLC in Washington. "The challenge is figuring out what the broader solution is."

Lehman can borrow overnight from the central bank, with escalating costs if it keeps using the program. Because it's a stopgap, speculation may mount that the government will again intervene to prevent a large financial company from failing, after the Bear Stearns rescue and takeovers of Fannie Mae and Freddie Mac.

"Given what was done with Freddie and Fannie and Bear Stearns, it's hard to distinguish why Lehman is not too big to fail as well," says Robert Eisenbeis, chief monetary economist at Cumberland Advisors, and a former research director at the Atlanta Fed. "My guess is that everyone will blink again and Lehman too will be saved. We are in for a rough ride."

Talking to officials

The Fed is getting updates on Lehman's capital and leverage positions from its examiners, who have been reviewing the company's finances and those of other major investment banks since the formation of the PDCF in March. Treasury officials are "in regular contact with market participants," spokeswoman Jennifer Zuccarelli says.

Lehman last week reported a $3.9 billion third-quarter loss and says it plans to sell a majority stake in its investment-management unit. Company officials didn't mention any use of the PDCF in a conference call with analysts today.

Fed spokeswoman Michelle Smith in Washington declined to comment yesterday.

New York-based Lehman, the fourth-biggest U.S. securities firm, tumbled 45% yesterday in New York trading after talks about a capital infusion from Korea Development Bank ended. The shares, which had lost 88% this year, rose 50 cents to $8.29 at 9:55 a.m. today.

The cost of buying protection against default on Lehman debt surged 1.5 percentage points to 4.75 percentage points, credit-default swaps showed, according to broker Phoenix Partners Group.

No repeat

Fed Chairman Ben S. Bernanke says he wanted to avoid an episode similar to the Bear Stearns rescue in March, when the central bank agreed to lend $29 billion to secure the investment bank's takeover by JPMorgan Chase & Co. That was part of an agreement crafted in part by New York Fed President Timothy Geithner, after consultations with Treasury Secretary Henry Paulson.

"The financing we did for Bear Stearns is a one-time event," Bernanke said in April. "It's never happened before and I hope it never happens again."

The PDCF offers the 19 primary dealers that trade Treasuries with the New York Fed access to direct loans at the same rate as commercial banks, now 2.25%. Dealers can submit collateral including Treasuries and asset-backed debt, corporate bonds and municipal bonds with investment grades.

For seven of the past nine weeks there has been no borrowing from the PDCF, with average weekly balances of $3 million and $9 million for the other two. The Fed releases its weekly borrowing statistics each Thursday at 4:30 p.m. New York time.

In July, the Fed extended the PDCF through Jan. 30 because of "continued fragile circumstances in financial markets." It was originally set to end as soon as this month.

'Help a lot'

The PDCF "should help a lot" for Lehman, former Fed Governor Lyle Gramley says. If Bear Stearns had had access to the funding, it's "conceivable" the firm might not have been pushed into its acquisition by JPMorgan, says Gramley, now senior economic adviser at Stanford Group Co. in Washington.

Both Bear Stearns and Lehman suffered from the collapse of the mortgage-backed securities market in the wake of a record surge of delinquencies on U.S. home loans. The crisis then spread to other markets, including for some types of student-loan and municipal debt.

Lehman is trying to raise capital and dump devalued real-estate assets after $8.2 billion in writedowns and credit losses in the past year.

For the Fed, the Bear Stearns and PDCF lending marked the first extension of credit to nonbanks since the Great Depression, using emergency authority to act in "unusual and exigent circumstances."

Any Fed rescue of Lehman may deepen criticism among some current and former central bankers about the danger of moral hazard - where firms take on more risk in anticipation of government aid if their bets go wrong. Richmond Fed President Jeffrey Lacker and his Philadelphia counterpart Charles Plosser both raised those concerns in June.

"The Fed has shown a willingness to lend liberally," says Gerald O'Driscoll, a former vice president of the Dallas Fed and now a scholar at the Cato Institute in Washington. The Bear Stearns lending "left markets unsure what the Fed would do in the future. Each time you do it, you reinforce the view that it will be done again," he says.