The Fed's Options

What's being done to stop the bleeding.

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The Federal Reserve and the world's largest banks are trying to come up with a plan to stop the crisis started by Lehman Brothers, and they're working to make sure short-term funding, the lifeblood of the financial sector, continues to flow.

Ten big banks are pooling $70 billion in a massive liquidity fund to smooth out the disruption (and that caused by Bank of America's bid for Merrill Lynch).

The Securities and Exchange Commission and the Treasury Department said late yesterday that they'd act to ensure a smooth transition.

All eyes will be on tomorrow's Federal Reserve meeting, which could be the most interesting one in Ben Bernanke's tenure as chairman.

So what has changed in the Fed's approach to the crisis, and will an emergency rate cut come after tomorrow's meeting?

From Fed-watcher Tim Duy at Economist's View:

Fed officials likely now understand the can of worms they opened with the Bear Stearns bailout. At that point, Wall Street realized that attempting to solve their own problems was a sucker's bet—better to string things along with the expectation that the Fed would ultimately solve the problem of bad assets by bringing them into the public domain. Arguably, this is one reason the Lehman issue was allowed to fester for another six months. Moral hazard. With policymakers now drawing a line in the sand, market participants can no longer cling to the hope that the Fed will absorb additional bad debt (notice how quickly Merrill moved when policymakers claimed they will serve only as matchmakers, rather than put additional public money explicitly at risk). It is looking like the endgame is finally here.

An emergency rate cut could indeed be on the way, though there's no real clarity either way right now. Analysts I've talked to float the idea that the Fed won't cut interest rates unless the European Central Bank gets on board to do the same. The Bank of England and the ECB have already extended lending, as has the Fed. Duy says this:

Cutting interest rates, I suspect, will make little if any difference at this juncture. That said, the Fed has delivered a rate cut at each critical juncture of the past year. I am at a loss to convincingly explain why this week is any different.

He's right that rate cuts really matter less than what the Fed will telegraph as its current view of this crisis. Allowing Lehman to fail marks the first time this year that the government has stepped back to let the market sort out its problems.

But don't expect a further retreat by the Fed, despite its tougher new stance. The Fed agreed to unprecedented new lending and will now accept a wide variety of lower-quality assets as collateral to help keep banks afloat. Given the unprecedented risks to the financial system generated by today's round of problems, Global Insight analysts say an emergency rate cut really will matter:

While the move by the Administration to put a line in the sand and not provide any backing for a bailout of another major financial institution is understandable, without supporting moves by the Fed to buffer the fallout in the form of an emergency rate cut, the risks to the financial system and the economy are massive.

The question is whether the Fed's decision now to walk away from bailing out another bank will cause more or less suffering in financial markets (and whether it will stick to a newly tough position as AIG struggles and reportedly looks for Fed support). With the Dow continuing to plummet today, it looks like more pain to come before talk of any rescue gets Wall Street's attention.