Fed acts to protect financial system

By Mark Felsenthal

WASHINGTON (Reuters) - The Federal Reserve announced on Sunday emergency measures to stem a fast-spreading financial crisis, cutting the discount rate it charges on direct loans to banks and setting up a new program to provide cash to big financial firms.

In a surprise statement, the central bank said it cut the discount rate to 3.25 percent from 3.5 percent, effective immediately, an action that puts that rate just a quarter point above the interbank overnight federal funds rate -- the Fed's primary policy tool.

It also said it was setting up a new lending program under which so-called primary dealers could borrow directly from the Fed at the discount rate.

"Liquid, well-functioning markets are essential for the promotion of economic growth," the Fed said.

The central bank said the new lending facility for the primary dealers -- big Wall Street firms with which it deals directly in financial markets -- would be open for business on Monday and would be kept in place for at least six months.

It is aimed "to improve the ability of primary dealers to provide financing to participants in securitization markets," the central bank said. The loans extended under the new program can be backed by a broad range of investment-grade debt securities as collateral.

Both actions were approved unanimously by the Fed's Board of Governors, which took the steps in concert with a decision to approve special financing to facilitate the purchase of ailing investment bank Bear Stearns by JPMorgan Chase &Co . Under the deal, the Fed agreed to fund up to $30 billion of Bear Stearns' less liquid assets.

The Fed also said it was increasing the maximum term for discount window loans to 90 days from 30 days.

The action was the latest in a series of extraordinary measures the U.S. central bank has taken to try to tamp down a broadening financial crisis that threatens to push the economy into a deep recession.

On Friday, the Fed said it would provide emergency funds to cash-strapped Bear Stearns through its discount window using JPMorgan Chase as an intermediary. Bear Stearns, which is one of 20 primary dealers, was unable to borrow directly from the window because -- until the latest action -- it had been open only to deposit-accepting banks.

"This evening's decision appeared to pre-empt the possibility of continuing to arrange ad hoc lending arrangements to other primary dealers who could face funding difficulties," said Michael Feroli, an economist at JPMorgan Chase.

Fed policy-makers are set to meet on Tuesday and are widely expected to lower the benchmark federal funds rate by up to a full-point to try to put a floor under an economy many believe is already in the throes of recession.

The central bank began lowering the overnight rate in mid-September and has taken it down to 3 percent from 5.25 percent, but the impact of the Fed's monetary easing has been undercut by credit markets that remain unusually tight.

(Reporting by Mark Felsenthal; Writing by Tim Ahmann; Editing by Tim Dobbyn)

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