April 17 (Bloomberg) -- Federal Reserve Bank of San Francisco President Janet Yellen signaled that it was a mistake to allow Lehman Brothers Holdings Inc. to collapse, saying the firm was “too big to fail” and its bankruptcy caused a “quantum” jump in the magnitude of the financial crisis.

“I am told that Lehman had insufficient collateral” for the Fed to provide loans, Yellen said after a speech in New York yesterday. She noted that she was “sitting in California” at the time of the Fed deliberations and “wasn’t involved in anything having to do with it.”

Yellen’s remarks are the strongest to date by a Fed official blaming the Lehman failure for a worsening in the crisis. She echoed calls by Chairman Ben S. Bernanke for new powers for federal authorities to take over and resolve failing nonbank financial firms.

The San Francisco Fed chief, a chairman of former President Bill Clinton’s Council of Economic Advisers and ex Fed governor, also said she now sees a case for using Fed tools to prick asset bubbles to head off systemic crises.

The impact of Lehman’s failure “was devastating,” Yellen said yesterday. “That’s when this crisis took a quantum leap up in terms of seriousness.”

No Buyer

Lehman was forced into bankruptcy on Sept. 15 after a weekend of negotiations at the Federal Reserve Bank of New York failed to produce a buyer and Fed and Treasury officials decided not to provide the firm with a loan.

Credit markets froze in the days after Lehman’s failure. Commercial paper markets almost ceased functioning as lenders shunned risk and the spread between the London Interbank Offered Rate, a measure of banks’ willingness to lend, and the average rate on overnight swaps soared.

An investor rush to Treasuries as a haven sent yields on three-month bills as low as negative 0.02 percent in December. The disruption to money markets caused the Reserve Primary Fund to become the first money fund in 14 years to “break the buck,” the term for falling below the $1 a share.

The spread between three-month dollar Libor and the overnight indexed swap rate has retreated in recent weeks, offering some signs of an easing in the crisis. The gap narrowed to 0.91 percentage point today from a high of 3.64 percentage points in October. It was less than 1 percentage point before Lehman’s collapse.

Yellen Disagreed

Yellen said she disagreed with Fed officials who argued in September that a government bailout of Lehman would encourage excessive risk-taking among investors. She commented in response to an audience question after a speech sponsored by the Levy Economics Institute of Bard College

“Lehman was a systemically important institution,” said Yellen, 62, who sits on the Fed’s policy-setting Open Market Committee this year.

Without a suitable “tool box,” Fed officials have been forced to improvise throughout the credit crisis, Yellen said.

Congress should “pass legislation that would provide for the orderly wind-down of a non-bank institution,” she said. “I’m sure it would have been used in the case of Lehman,” Yellen said, while declining to label the decision not to rescue Lehman an error.

“Bear Stearns, Lehman, AIG -- these have all been horrendous, miserable situations,” Yellen said. “We’re pushing the envelope of our powers, but we’re choosing to do that because the consequence of failing to do that seem unthinkable.”

Asset Bubbles

Yellen also said she no longer opposes using the central bank’s policy tools to avert harmful asset-price bubbles similar to the one in U.S. housing this decade.

“Now that we face the tangible and tragic consequences of the bursting of the house price bubble, I think it is time to take another look,” she said in her speech. “What has become patently obvious is that not dealing with certain kinds of bubbles before they get big can have grave consequences.”

Yellen’s remarks make her at least the second Fed official after Gary Stern, of Minneapolis, to rethink the central bank’s hands-off approach toward bubbles, an article of faith during former Chairman Alan Greenspan’s 18-year tenure. The Fed’s low interest-rate targets between 2002 and 2004 were partly to blame for the easy credit and housing-price escalation that led to the current financial crisis, the San Francisco bank president said.

‘Tighter’ Policy

“I would not advocate making it a regular practice to use monetary policy to lean against asset price bubbles,” Yellen said in a speech at the conference. “However, recent experience has made me more open to action. I can now imagine circumstances that would justify leaning against a bubble with tighter monetary policy.”

While Yellen’s remarks are unlikely to result in immediate monetary-policy changes, they demonstrate how officials are questioning long-held ideas about the Fed’s role in markets. Yellen has led the San Francisco Fed since 2004.

A report yesterday showed that San Francisco Bay Area home prices fell a record 46 percent in March from a year earlier, the 16th month of declines.

Data released this week on employment and other areas of the economy suggest that the U.S. slump is easing. The reports buttress Bernanke’s assessment this week that the “sharp decline” in the economy appears to be moderating.

The economy, in areas such as home sales and consumer confidence, is showing “tentative signs” that the decline is slowing, Bernanke said in an April 14 speech in Atlanta. He added that “a leveling out of economic activity is the first step toward recovery.”

The central bank said in its Beige Book business survey on April 15 that the contraction slowed across several of the biggest regional economies last month, with some industries “stabilizing at a low level.”

“While we’ve seen some tentative signs of improvement in the economic data very recently, it’s still impossible to know how deep the contraction will ultimately be,” said Yellen.

To contact the reporter on this story: Vivien Lou Chen in San Francisco at vchen1@bloomberg.net; Michael McKee in New York at mmckee@bloomberg.net;

Last Updated: April 17, 2009 08:21 EDT