With the financial crisis seemingly far from over in the United States., analysts are predicting more aggressive action from the U.S. government to stabilize markets.

In a research note, Global Insight Inc. says that the sudden bankruptcy of Lehman Brothers, “has led to another dangerous escalation of the crisis in the U.S. financial markets –a crisis that has been seriously harming the performance of the economy for more than a year.”

It notes that the decision not to engineer that another bailout are understandable, but argues that, “without supporting moves by the Federal Reserve to buffer the fallout in the form of an emergency rate cut, the risks to the financial system and the economy are massive.”

The Fed did attempt to offer a longer lifeline over the weekend with additional measures to boost liquidity. “Central banks around the world injected additional liquidity into money markets over the weekend and the Fed announced additional measures to limit the fallout from the Lehman bankruptcy. Stunningly, the Fed is even prepared to take stock market risk directly onto its balance sheet, accepting equities as collateral at the Primary Dealers Credit Facility,” observes BCA Research. However, it adds that these measures “have done little to quell investor panic, with stocks plunging and capital fleeing into safe havens such as government bonds.”

BMO Capital Markets points out that there is a great deal of uncertainty in the market about just what the Fed did do over the weekend. “There appears to be a good deal of opacity in what the Fed has said regarding a broadening of the collateral it is willing to hold on short-term emergency loans to primary dealers,” it notes. “The markets are scrambling for the precise meaning of this statement. In addition, it is unclear just how much in the way of high-risk collateral the Fed would be willing to accept.”

Uncertainty is also rife in certain markets, including, BCA Research points out, the “massive global credit default swap market, especially for those contracts in which Lehman acted as the counterparty.”

BMO Capital’s chief economist, Dr. Sherry Cooper, adds, “What is different about this financial crisis in comparison to the others in my career is the lack of transparency. The exotic financial instruments created this time are very difficult to price. The effects are less contained than in the past and they are larger given that they emanate from the subprime crisis and directly affect the net worth of households.”

“Moreover, a similar housing crisis appears to be growing in England, Ireland and Spain and much of Europe is moving toward recession, as is Japan. Even China cut short-term interest rates overnight for the first time in six years, which underscores how concerns over problems in the U.S. are impacting economic policy worldwide,” she adds.

Indeed, Global Insight stresses that the economy and the financial markets were already extremely weak, and, “The bankruptcy of Lehman Brothers will put further deflationary pressure on financial markets and the economy at a time when such pressure can be ill-afforded.”

“While the large loan program announced by major global banks today may help ease the shock, we should not delude ourselves into thinking that without a significant move from the Fed there will not be further tightening of credit conditions as a result of the events over the weekend. That will threaten the U.S. economy and the financial system even further,” it warns.

Also, the failure of Lehman is likely to put additional downward pressure on asset prices, putting other major financial institutions at risk. “Under this destabilizing scenario, Congress would come under incredible pressure to craft another fiscal-stimulus plan, and there is also a strong likelihood it would need to step in and capitalize a major government financial entity that would purchase distressed financial system assets, along the lines of the Resolution Trust Corporation—both outcomes of course at massive taxpayers’ expense,” it suggests.

“This is an emergency situation and an aggressive response from the Fed is needed,” the firm concludes. “Without such a response, pressure on Congress to take further action to stem the crisis would be unstoppable. In this case, the cost to taxpayers will escalate massively and burden American households with additional government debt for years to come.”

BCA adds that the pressure on policymakers to provide relief is soaring, and it says that the Fed may yet cut rates again. “It is surprising that the European central banks have not eased already, but rate cuts are probable if financial markets continue to melt,” BCA concludes. “Longer term, it appears increasingly likely that a major U.S. government fiscal package aimed at struggling homeowners and/or impaired assets on banks’ balance sheets will ultimately be required. Unfortunately for investors, such a package will take time.”

@page_break@BMO also notes that markets are now expecting the Fed to cut rates 25 basis points tomorrow, “although there was no realmacroeconomic reason for them to do so prior to last night.”

“One thing is certain, the Fed will do whatever it takes to calm financial markets. Inflation is no longer a major concernwith oil and other commodity prices falling, but these price declines continue to drive down materials and energy stock prices in Canada,” it concludes.

IE