March 17 (Bloomberg) -- The Federal Reserve, struggling to prevent a meltdown in financial markets, cut the rate on direct loans to banks and became lender of last resort to the biggest dealers in U.S. government bonds.

In its first weekend emergency action in almost three decades, the central bank lowered the so-called discount rate by a quarter of a percentage point to 3.25 percent. The Fed also will lend to the 20 firms that buy Treasury securities directly from it. In a further step, the Fed will provide up to $30 billion to JPMorgan Chase & Co. to help it finance the purchase of Bear Stearns Cos. after a run on Wall Street's fifth-largest securities firm.

``It is a serious extension of putting the Federal Reserve's balance sheet in harm's way,'' said Vincent Reinhart, former director of the Division of Monetary Affairs at the Fed and now a scholar at the American Enterprise Institute in Washington. ``That's got to tell you the economy is in a pretty precarious state.''

The move is Chairman Ben S. Bernanke's latest step to alleviate a seven-month credit squeeze that's probably pushed the U.S. into a recession. The dollar tumbled to a 12-year low against the yen and Treasury notes rallied as traders increased bets that officials will reduce their main rate by 1 percentage point when they meet tomorrow.

`Race to the Bottom'

``Clearly, the Fed is trying to provide more liquidity to prevent a more vicious cycle and race to the bottom,'' said Gary Schlossberg, senior economist at Wells Capital Management in San Francisco, which oversees $200 billion. ``The problem is there's so much concern about credit quality that now there are solvency issues, and it's something the Fed has a more difficult time dealing with.''

The Bank of England said today it will offer 5 billion pounds ($10 billion) of extra three-day funds in an emergency fine-tuning operation. The European Central Bank and the Swiss National Bank declined to comment on whether they're planning any measures.

U.S., Asian and European equities slumped. The Standard & Poor's 500 Index fell 1.1 percent to 1273.46 as of 10:12 a.m. in New York. Europe's Dow Jones Stoxx 600 Index dropped 3.7 percent, while the MSCI Asia Pacific Index tumbled 2.3 percent.

The dollar sank to a record low against the euro and the Swiss franc and fell to the weakest in 12 years against the yen, helping push gold and crude oil to highs.

`Credit Crunch'

``We've got a credit crunch situation in every corner of the market,'' said Tetsuro Sugiura, chief economist at Mizuho Research Institute Ltd. in Tokyo. ``The near collapse of Bear Stearns has shocked the authorities.''

Officials from the Fed and the Treasury Department, including Treasury Secretary Henry Paulson, worked with the firms over the weekend to forge an agreement on the sale of Bear Stearns. Paulson kept President George W. Bush informed through the weekend, said White House spokesman Tony Fratto.

The Fed reduced the difference between the discount rate and the main federal funds rate to a quarter point. In August, at the onset of financial-market pressures, the Fed narrowed the spread to a half point from 1 percentage point. The funds rate, currently 3 percent, is the rate banks charge each other for overnight loans.

Fed's Shift

The Fed has lowered its benchmark overnight rate five times and the discount rate seven times since the middle of August, when the collapse of U.S. subprime mortgages started to infect markets around the world. Since then, the S&P 500 stocks index has dropped 11 percent and the dollar has fallen 15 percent against the euro.

Opening up lending to firms other than commercial banks represents a shift in the Fed's 94-year history. The so-called primary dealers include firms that are units of commercial banks and several that aren't, including Goldman Sachs Group Inc., Morgan Stanley and Merrill Lynch & Co.

Bernanke, 54, is increasing efforts to keep strains in financial markets from spiraling into a full-blown meltdown. Last week, the central bank agreed to emergency loans to a non- bank, Bear Stearns, for the first time since the 1960s. Fed officials also announced a program to swap $200 billion in Treasuries for debt including mortgage-backed securities.

``These moves underscore the extreme sense of urgency at the Fed,'' said David M. Jones, a former New York Fed economist who has written four books on the central bank. ``It seems unlikely the measures taken so far will calm the market down, but eventually they will stabilize the market.''

JPMorgan Agreement

JPMorgan Chief Executive Officer Jamie Dimon yesterday agreed to buy Bear Stearns, the second-biggest underwriter of U.S. mortgage securities, for $240 million, less than a 10th of its value last week. In order to strike a deal before the opening of Tokyo trading, the Fed agreed to help JPMorgan finance up to $30 billion of Bear Stearns's ``less liquid assets.''

``Jamie Dimon's done a great deal because the Federal Reserve is paying for it,'' said investor Jim Rogers, who co- founded the Quantum Hedge Fund with George Soros in the 1970s, during an interview with Bloomberg Television.

The Fed is in effect assuming responsibility for managing the assets, a Fed official told reporters in a conference call. The central bank will manage the positions to minimize any market strains and maximize long-term value, said the official, who spoke on condition of anonymity.

Rare Move

``We learned that Bear Stearns's balance sheet on close examination was worth a 10th of its market value,'' said Reinhart. ``Second, the Federal Reserve wants to be sure the other entities coming to them are covered by a broader umbrella,'' he said, referring to the primary dealers.

Shifting policy on a weekend is rare, though not unprecedented. About two months after Paul Volcker took office as Fed chief in 1979, he called a Saturday meeting of the Federal Open Market Committee to raise interest rates.

Yesterday's events are ``nothing like the 1970s, which was about fighting inflation,'' said Jones. ``This is fighting a negative, self-reinforcing process'' of sliding collateral values, tighter bank credit and weakening economic conditions, he said.

Starting today, the dealers who trade with the New York Fed bank daily will be able to borrow at the discount rate under a new lending facility, to be in place for at least six months, the Fed said. The Fed will accept a ``broad range'' of investment-grade collateral.

``These steps will provide financial institutions with greater assurance of access to funds,'' Bernanke said during a conference call with reporters after the announcement.

Rate Cut Expected

Investors expect the Fed to lower its separate benchmark rate by as much as a percentage point, to 2 percent, when policy makers meet tomorrow. That would exceed the 0.75-point emergency reduction on Jan. 22, which is the largest since the overnight interbank lending rate became the main tool of monetary policy about two decades ago.

Yesterday's steps indicate the Fed is increasingly concerned about the investor exodus from mortgage debt, which threatens to deepen the housing contraction.

The central bank on March 11 announced it will for the first time lend Treasuries in exchange for debt that includes mortgage-backed securities held by dealers to facilitate market- making. It holds about $713 billion of Treasuries on its balance sheet.

On March 7, the Fed said it would make $100 billion available through repurchase agreements, where the Fed loans cash in return for assets including mortgage debt issued by Fannie Mae and Freddie Mac.

New York Fed President Timothy Geithner said on the call that ``this is designed to help get liquidity to where it can help play an appropriate role in helping address the range of challenges facing particularly asset-backed securities markets.''

Fed governors agreed that the ``unusual and exigent circumstances,'' as stated in the Federal Reserve Act, existed for approving the lending to primary dealers, a Fed official said on the conference call. The actions were approved by all five members, a Fed official said.

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     Following is a list of primary dealers in government
securities:

BNP Paribas Securities Corp.
Banc of America Securities LLC
Barclays Capital Inc.
Bear, Stearns & Co., Inc.
Cantor Fitzgerald & Co.
Citigroup Global Markets Inc.
Countrywide Securities Corporation
Credit Suisse Securities (USA) LLC
Daiwa Securities America Inc.
Deutsche Bank Securities Inc.
Dresdner Kleinwort Wasserstein Securities LLC.
Goldman, Sachs & Co.
Greenwich Capital Markets, Inc.
HSBC Securities (USA) Inc.
J. P. Morgan Securities Inc.
Lehman Brothers Inc.
Merrill Lynch Government Securities Inc.
Mizuho Securities USA Inc.
Morgan Stanley & Co. Incorporated
UBS Securities LLC.

Source: Federal Reserve Bank of New York
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To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net

Last Updated: March 17, 2008 10:22 EDT