Fed To Boost Lending Ahead of Lehman Bankruptcy

The US Federal Reserve announced that it would boost the Term Securities Lending Facility and the Primary Dealer Credit Facility. The move is designed to create access to liquidity ahead of tomorrow's expected announcement that investment bank Lehman Brothers has filed for bankruptcy after authorities failed to line up buyers for the troubled firm. The Fed said in a statement they have been working closely with the SEC and the Treasury department "to identify potential market vulnerabilities in the wake of an unwinding of a major financial institution and to consider appropriate official sector and private sector responses." Alluding to the recently announced $70 billion liquidity pool created by 10 top banks, the Fed also said that "the steps we are announcing today, along with significant commitments from the private sector, are intended to mitigate the potential risks and disruptions to markets."

Major Banks Team Up To Avoid Meltdown, Bank of America Buys Merrill Lynch

Having reportedly backed out of talks to buy troubled bank Lehman Brothers, Bank of America was reported to have reached an agreement to purchase another major investment bank, Merrill Lynch. The deal is valued at $44 billion. Meanwhile, a consortium of 10 major banks agreed to create an emergency liquidity pool worth $70 billion to avoid further meltdown. The group is reported to include Bank of America, Deutsche Bank, Credit Suisse, UBS, Citibank, JPMorgan, Morgan Stanley, Goldman Sachs and Barclays.

As for Lehman Brothers, it looks increasingly likely they will declare bankruptcy. The International Swaps and Derivatives Association held a special trading session today allowing its member banks (218 in total) to begin squaring their Lehman-linked exposure. However, these trades will be void should Lehman somehow manage to avoid the worst case scenario, bringing substantial volatility to the markets. A bank holiday has Tokyo closed for trading today, meaning forex traders could have to wait until the London open to see the extent of what these developments will do to risk sentiment and the US dollar.

Barclays, Bank of America Pull Out of Lehman Buyout

Key investors Bank of America and Barclays Plc have reportedly decided not to buy troubled investment bank Lehman Brothers this morning. Barclays walked away from the deal after they could not obtain government protection from loses on Lehman's assets. Lehman Brothers had suffered a crippling blow this year, losing 94% of its market value on mortgage-linked investments. Although US authorities had facilitated lining up buyers for the troubled investment house, Treasury Secretary Henry Paulson has remained adamant that tax payers' funds would not be used to bail out the firm as had been done with Bear Sterns as well as mortgage giants Fannie Mae and Freddie Mac. Paulson stressed that Lehman was different because the markets had time to prepare for its possible demise. Federal Reserve Chairman Ben Bernanke added that he hoped the Bear Sterns bail-out had been a one-off affair rather than something that sets a precedent. The International Swaps and Derivatives Association held a special session today allowing its member banks (218 in total) to begin squaring their Lehman-linked exposure ahead of a possible bankruptcy filing later in the day.

How does this affect the forex market?

Last week, we observed an inverse relationship between the performance of global equities and the US dollar: the greenback sold off as stocks rallied following the bailout of Fannie May and Freddie Mac only to see the move reverse course as stock markets were spooked by troubles at Lehman Brothers and the dollar boomed across the board. We suggested that the relationship owed to cross-asset capital flows: fears of a collapse at a major institution (Fannie/Freddie, Lehman) saw investors cash out of risky assets (i.e. stocks). Considering the interest rate outlook for 2009, it makes sense that the cash of choice was the US dollar. Indeed, bond yields forecast that the Federal Reserve will begin raising rates in 2009 while most other central banks will cut them. Friday saw stock markets rally and the greenback give back ground against the majors (including its Australian counterpart) as the US Federal Reserve and Treasury department were said to be in the process of lining up buyers for Lehman Brothers. The Dollar remains near Friday's closing levels for the time being, but risk aversion may return with a vengence as the Tokyo trading session gets underway. US equity index futures are sharply lower in overnight trading, suggesting the dollar could mount a punishing rally if last week's patterns are to hold.

DailyFX

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