Central banks try to calm markets in financial storm

Central banks moved worldwide to ease tensions and address deep distrust in short-term lending markets after Lehman Brothers Holdings Inc filed for bankruptcy protection and news that Merrill Lynch, another Wall Street giant long seen as too big to fail, was being sold.
As U.S. interbank lending rates jumped to triple the official target rate the U.S. central bank sets, the Federal Reserve pumped $70 billion of temporary reserves into the banking system in an effort to get short-term cash flowing again to borrowers in dire need of funds.
The hefty injection worked, for a day at least. By late Monday, elevated strains abated and the fed funds rate dropped below 1 percent.
"The Fed this morning supplied vastly more reserves than the system will need at the end of the day. Unfortunately, for much of the day that was not enough to get funds trading," said Lou Crandall, chief economist at Wrightson ICAP in Jersey City, New Jersey.
"The amount of reserves supplied was so far out of scale with end-of-day needs that the Fed knew that it was going to force the funds rate to crash at the end of the day," Crandall added.
Market participants' persistent concerns about other financial institutions could put lending markets under renewed stress at any moment.
New York Gov. David Paterson said he and other state officials had reached an agreement with American International Group Inc, once the world's largest insurer by market value, to give AIG access to $20 billion of its own capital, preventing a liquidity crisis.
The Federal Reserve Bank of New York was hosting meetings on AIG on Monday with representatives of the U.S. Treasury, financial services companies and state officials, a New York Fed spokesman said.
The Fed has asked JPMorgan Chase and Goldman Sachs to explore arranging $70 billion to $75 billion in loans to support AIG, among other financing options, a person familiar with the situation said.
"We hope that we don't see a crisis which pushes the global economy to the brink of ruin," said German Economy Minister Michael Glos.
Central bankers had their work cut out. Stock prices sank and demand soared for extra short-term lending offered in an attempt to sustain the system that oils the wheels of modern capitalism.
OVERNIGHT BORROWING COSTS SOAR
On the interbank market, overnight dollar borrowing costs surged almost 1 percentage point to the highest in nearly three months, indicating banks are hoarding cash rather than lending it.
"It is clear there is hoarding of bank reserves going on in the financial system," said Tony Crescenzi, chief bond market strategist with Miller, Tabak & Co. in New York.
Smaller banks tend to have excess short-term funds and were apparently reluctant to lend them, he said.
Reflecting the strains in interbank markets, at one point the spread of U.S. federal funds in the market over the official rate the Federal Reserve sets was on track to widen to the most in about 20 years, Crescenzi said.
In a sign that short-term markets were freezing up, analysts said U.S. federal funds briefly traded at 6 percent, triple the 2 percent fed funds target rate, the official rate the Federal Reserve sets for interbank lending.
Monday's $50 billion overnight Fed repo was the largest single such operation since Sept. 17, 2001, in the aftermath of the attacks on New York and Washington. Monday's combined Fed money market operations total of $70 billion was the biggest daily addition since an $81.25 billion weekend repo on Sept. 14, 2001, the New York Fed said.
Global central banks' response started Sunday, when the Federal Reserve announced that central banks, regulators and supervisors were in close contact internationally and were monitoring events as they unfolded.
It announced emergency measures for lending operations that effectively relax the terms on which commercial banks can borrow from the U.S. central bank.
In Europe, the European Central Bank, as well as German, French, British and Swiss authorities, all responded in turn.
The ECB held a money market operation in which it allotted 30 billion euros in one-day liquidity to banks, only a third of the level demanded.
NOT ENOUGH?
Economists Jacques Cailloux and Gareth Claase at Royal Bank of Scotland said this high level of demand, similar to that seen when the credit crunch first forced the ECB into emergency mode in August 2007, showed how fragile the situation was.
"The ECB will likely take note that the financial system remains starved of cash and that it might thus be forced to step in again," they said.
The Bank of England put an extra 5 billion pounds into the financial system after receiving bids of nearly five times the amount of three-day funds available. The Swiss National Bank also provided extra liquidity to the money market.
The Bank of Japan added a total of 2.5 trillion yen ($24 billion) to the financial system and China cut interest rates as Asian central banks attempted to calm markets.
The bank-to-bank premium paid for overnight dollar funds was fixed at 3.10625 percent, according to the British Bankers Association's latest daily fixing, up nearly a percentage point to its highest level since late June.
In Asia, officials at Japan's central bank confirmed that the authorities were monitoring the situation closely, and the message was the same in Europe.
Safe-haven debt soared after emergency weekend talks failed to save 158-year-old Lehman from becoming the latest victim of the credit crisis.
Wall Street's woes prompted talk that the U.S. Federal Open Market Committee may cut its benchmark interest rate from 2.0 percent when it on Tuesday. Fed fund futures jumped Monday to indicate a 66 percent probability of a cut to 1.75 percent.
Ten of the world's top banks agreed to set up a $70 billion emergency fund, with any one of them able to tap up to a third of that.
NEW STEPS
On Sunday, the Fed said that among emergency measures, it will start accepting equities as collateral for cash loans at one of its special credit facilities for the first time in its 90-year history.
"We have been and remain in close contact with other U.S. and international regulators, supervisory authorities, and central banks to monitor and share information on conditions in financial markets and firms around the world," Fed Chairman Ben Bernanke said in a statement.
The ECB said in a brief statement: "The ECB stands ready to contribute to orderly conditions in the euro money market," a line the Bank of Canada echoed Monday.
Since the crisis started, global banks have written off some $500 billion in credit market losses. Lehman's filing for bankruptcy protection and Merrill Lynch's agreement to sell itself to Bank of America remove two more names from Wall Street's map, just months after Bear Stearns' near collapse. That means three of the top five have run into trouble in six months.