Federal Reserve staff move into offices of investment banks to monitor activities

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By Tom Bawden and Dearbail Jordan

The US Federal Reserve has sent staff into some of Wall Street’s biggest firms and its New York branch is gathering evidence on key traders’ activities as America’s central bank raises its scrutiny of risk to an unprecedented level.

Fed staff have set up shop in Goldman Sachs, Morgan Stanley, Lehman Brothers, Merrill Lynch, and Bear Stearns to monitor their financial condition just days after Henry Paulson, the US Treasury Secretary, proposed that the Fed become the financial industry’s “risk czar”.

This is the first time in more than a decade that the Fed has put staff in securities firms and is a response, in part, to its decision to extend to investment banks the “discount window” of cheap loans traditionally offered only to the commercial banks. The Fed argues that if it is to act as lender of last resort to the securities firms, it should keep a closer eye on their activities.

The move comes as the central bank’s New York branch separately compiles a list of names and numbers of key traders in specific, esoteric securities such as auction rate preferred securities. These obscure instruments can be traded only at auctions and demand for them has virtually evaporated in recent weeks.

A senior US mutual fund executive, whom the Fed has approached, said: “They are looking in every corner to understand every esoteric financial product — who its traders are, who holds the most, whether its market is liquid and how great the losses could be. They are approaching people like me to find the key players in particular securities and then contacting them to find out the details. I have never heard of that being done before.”

The Fed will use the information to ascertain how effective the measures it has taken so far have been, where in the financial system the biggest dangers lie and how best to curb them. Its action includes a 3 percentage point cut in the base rate since last August and a reduction in its discount window lending rate.

The Fed declined to comment on its attempts to increase its market scrutiny. However, Timothy Geithner, its president, speaking to Congress yesterday, said: “[The banking industry's] most important risk is systemic: if this dynamic continues, unabated, the result would be greater probability of widespread insolvencies, severe and protracted damage to the financial system and, ultimately, to the economy as a whole.” He cited “a self-reinforcing downward spiral” of asset sales, “higher volatility, and still lower prices”.

The market must stabilise to reduce the number of short-sellers seeking to push down the price of a company’s shares by spreading false rumours, analysts said yesterday. Shares in Lehman Brothers and Bear Stearns took a hammering last month after unfounded rumours surfaced that they faced a liquidity crisis.

The Financial Services Authority (FSA) is investigating unusual movement in HBOS shares. The watchdog is probing an unprecendented 20 per cent fall in the shares of the owner of the Halifax on the morning of 19 March amid speculation it was facing a Northern Rock style liquidity crisis. The Bank of England took the unusual step of publicly denying talk that it was cancelling staff holidays over Easter and convening emergency meetings to discuss a bank in crisis, describing the talk as “fantasy” while the FSA has been pledged new powers to help it to crack down on so-called market abuse.

Mr Paulson has made the management of risk a central part of his proposals to overhaul US financial regulations, many of which date back to the Great Depression. Banks have lost more than $232 billion worldwide so far as a result of the credit crunch and losses will continue to mount for some time.