Fed funding loosened after Lehman fails

Lehman Brothers did not, in the end, qualify for any more US government assistance, with the firm allowed to fail yesterday. But many other Wall Street banks and investment banks, and more, turn out to do so as a consequence of the failure of America's fourth-largest investment bank yesterday.

The key response of US financial regulators to responding to any contagion from the failure of Lehman was to drastically widen the pool of securities that banks may sell to the US Federal Reserve under short-term financing operations.

The Fed expanded the collateral accepted under its Term Securities Lending Facility to include all investment-grade debt securities. So instead of banks being eligible to sell only Treasury securities, agency securities (such as those of Fannie Mae and Freddie Mac), and AAA-rated mortgage-backed and asset-backed securities, the Fed will now accept any corporate or asset-backed security currently rated as low as BBB.

The Fed also broadened, in an ill-defined way, the pool of securities that banks may pledge under the Primary Dealer Credit Facility (a funding back-stop itself created only back in March in the days leading up to the Fed-orchestrated JP Morgan takeover of Bear Stearns).

The Fed said that they also broadened this "to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks. Previously, PDCF collateral had been limited to investment-grade debt securities."

A clear definition of what currently is acceptable under tri-party repos proves an elusive beast. The tri-party repo market is largely the creation of a handful of clearing banks and custodians (the third party). One feature of the tri-party repo market is that it has grown exponentially in recent years and that a considerable portion of this form of short-term funding is concentrated late in the dealing day.

Also of interest is that a committee of US worthies - the Counterparty Risk Management Group, headed by former Fed heavyweight Gerald Corrigan - advised the US Treasury and US Fed in a report only five weeks ago that "generally speaking, extraordinary central bank facilities, such as the Federal Reserve System's Primary Dealer Credit Facility, should not be considered an element of an effective liquidity plan."