Tuesday, July 8, 2008

Bernanke Says Fed May Continue Lending Into Next Year (Update3)

By Scott Lanman

July 8 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke, seeking to allay renewed concerns over the health of the nation's financial system, said the central bank may extend its emergency-loan program for investment banks into next year.

``The Federal Reserve is strongly committed'' to financial stability and is ``considering several options, including extending the duration of our facilities for primary dealers beyond year-end,'' Bernanke said in a speech to a conference in Arlington, Virginia.

The Fed chairman's comments come a day after Fannie Mae and Freddie Mac fell to their lowest level since 1992 and the Standard & Poor's 500 Banks Index dropped to a 12-year low. It's the first time Bernanke has indicated how long he'll extend the lending programs that were introduced in March in a provision of Fed credit to nonbanks unprecedented since the Great Depression.

Bernanke also endorsed proposals to set up a federal liquidation process for a failing investment bank. The Treasury should ``take a leading role in any such process'' in consultation with regulators, he said. Such a resolution mechanism may help reduce concern that investors and dealers begin counting on Fed aid in case their bets go wrong.

The Fed started the unprecedented lending programs for investment banks in March under its authority to lend to nonbanks in ``unusual and exigent circumstances.'' Officials said at the time the Primary Dealer Credit Facility, which provides direct loans, would last for ``at least'' six months.

Rate Outlook

Continued lending to investment banks may make it harder for the Fed to raise interest rates this year. Traders estimate 74 percent odds of at least quarter point increase in the 2 percent benchmark rate by year-end.

``There was some speculation that, come September,'' the lending programs ``might be allowed to expire,'' Dominic Konstam, head of interest-rate strategy at Credit Suisse Securities USA LLC in New York, said in a Bloomberg Radio interview. ``A lot of people would have thought that might be a prelude to the Fed beginning a tightening cycle. Now, that is obviously that much more uncertain.''

The S&P 500 Banks Index, a measure of 22 firms including Fannie Mae and Freddie Mac, the largest sources of U.S. home financing, fell to 155.48 yesterday, its lowest level since 1996.

Fannie Mae, based in Washington, and McLean, Virginia-based Freddie Mac have dropped more than 60 percent this year, with declines accelerating in the past two weeks, on concern that the capital the companies have raised since December may not be enough to overcome writedowns.

FDIC Conference

Bernanke didn't comment on the outlook for the economy or monetary policy in his remarks today to a Federal Deposit Insurance Corp. forum on mortgage lending.

The PDCF and the Fed's Term Securities Lending Facility, which auctions as much as $200 billion in Treasuries, are both aimed at the 20 primary dealers in U.S. government debt.

Fed officials are working with the Securities and Exchange Commission and securities dealers ``to increase the firms' capital and liquidity buffers,'' Bernanke said.

The remaining four major investment banks, after Bear Stearns Cos.'s takeover by JPMorgan, are Lehman Brothers Inc., Merrill Lynch & Co., Morgan Stanley and Goldman Sachs Group Inc.

Bernanke said ``it is worth the effort'' for lawmakers to design a resolution ``regime'' for securities firms. Treasury Secretary Henry Paulson and FDIC Chairman Sheila Bair have also advocated such a mechanism, which already exists for commercial banks.

`High Bar'

``By setting a high bar for such actions, the adverse effects on market discipline could be minimized,'' the Fed chief said today. His call for a leading role for the Treasury is in line with Paulson's July 2 remark that ``any commitment of government support should be an extraordinary event that requires the engagement of the executive branch.''

In the case of commercial banks, the use of taxpayer funds in an emergency requires the approval of two-thirds majorities of the FDIC and Fed boards, and of the Treasury secretary in consultation with the president.

JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon told the same conference that he supported Fed and Treasury proposals for ``policies, because of what happened, to take proper action if a large investment bank goes bankrupt.''

Without any liquidation procedure in place, the Fed in March decided to make a bridge loan to keep Bear Stearns out of bankruptcy. The central bank then agreed to take on $30 billion of hard-to-trade Bear Stearns assets to help secure its takeover by JPMorgan.

JPMorgan's Dimon

``The Federal Reserve in essence bought $30 billion of mortgage product from Bear Stearns; I want to remind people we bought $350 billion,'' Dimon said today. ``We don't really think'' the deal will end up costing taxpayers money, he also said.

Securities firms have cut back on their use of the programs in recent weeks. The balance of loans outstanding from the PDCF dropped to zero as of July 2, the first time that's happened since the program began. On March 26, the end of the first full week of operation, the PDCF had a balance of $37 billion.

Bids in the TSLF's weekly auctions, in which dealers swap securities such as mortgage-backed debt for Treasuries from the New York Fed, have declined since the start of the program. In the July 3 operation, firms submitted bids for $26.1 billion out of $50 billion of Treasuries offered.

One gauge of financial stress watched by the Fed has remained elevated. The difference between the overnight indexed swap rate, a measure of what traders expect for the Fed's benchmark rate, and three-month interbank loans in dollars was 0.74 percentage point today, up from 0.64 percentage point a month ago.

`Remained Strained'

``Although short-term funding markets remain strained, they have improved somewhat since March,'' Bernanke said.

Congress should legislate ``consolidated supervision'' of investment banks and other big securities firms, with the unspecified regulator having authority over capital, liquidity holdings and risk management, Bernanke also said today.

The Fed should also get ``explicit oversight authority'' over payment and settlement systems, putting the it on a par with counterparts from around the world, Bernanke said.

U.S. central bankers will already play a part in setting capital cushions at securities firms under an agreement yesterday with the SEC. The two agencies will collaborate in determining ``guidelines or rules concerning the capital, liquidity and funding'' arrangements of investment banks, the accord said.

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