Wall St. woes force U.S. to seek cash for Fed

WASHINGTON/LONDON (Reuters) - The U.S. government sought to raise $40 billion (22 billion pounds) on Wednesday to help its central bank finance a rescue plan for insurance giant AIG as the cost of staving off crisis on Wall Street soared.

Other central banks also battled to restore confidence on financial markets as share prices gave up brief gains they had made on news of the AIG bailout and the cost of short-term borrowing remained high in interbank markets.

The U.S. Treasury Department said it was selling $40 billion of cash management bills -- effectively new debt -- at the request of the Federal Reserve to help the central bank "better manage their balance sheet", as a Treasury statement put it.

Asian central banks ploughed extra liquidity into short-term funding markets, though many central banks in Europe took their foot off the pedal amid signs of a respite from the sharp surges in short-term borrowing costs seen in the previous two days.

The Bank of England said it would allow banks an extra three months to swap risky assets for government paper, extending a scheme that was set to close next month because of the latest turmoil in financial markets..

Dominique Strauss-Kahn, head of the International Monetary Fund, said there could well be more trouble in what former U.S. Treasury Secretary Robert Rubin dubbed "the worst crisis since the 1930s".

"The consequences for some financial institutions are still in front of us," Strauss-Kahn told reporters in Saudi Arabia.

Overnight, news broke that the U.S. authorities had come up with the rescue of American International Group (AIG) just two days after choosing to allow investment bank Lehman Brothers file for bankruptcy protection.

The bailout, in which the New York Federal Reserve offers up to $85 billion in loans in return for an AIG stake of nearly 80 percent, lifted stock markets from Asia to Europe until U.S. trading started, at which point U.S. and Europe indices tumbled.

COUNTING THE COST

But interbank lending and credit markets remained under pressure.

The bank-to-bank cost of overnight borrowing in dollars fell more than a percentage point but it rose for longer three-month funding, according to the latest London interbank offered rate (LIBOR) published by the British Bankers Association.

Overnight dollar Libor was fixed at 5.03125 percent compared with 6.43750 percent on Tuesday.

Earlier, such funding was quoted as costing nearer 8 percent in Europe, after levels in excess of 10 percent on Tuesday.

For three-month funding, however, LIBOR fixed almost 20 basis points higher at 3.06250 percent, versus 2.87625 percent on Tuesday.

More than $900 billion has been committed so far in U.S. government rescues and mortgage market intervention since the housing and sub-prime mortgage markets collapsed, triggering a credit crunch that is now in its second year.

German Chancellor Angela Merkel joined a lengthening list of political leaders expressing belief or hope that Europe would be spared some of the economic pain which is likely to follow the troubles of the big financial institutions.

"The effects until now on the real economy in Germany have been moderate," she told parliament. "However, an open economy like Germany's will not be able to escape completely unscathed."

In Britain, HBOS Plc bank confirmed it was in advanced talks that may lead to a takeover by domestic rival Lloyds TSB.

News of the talks surfaced after shares in HBOS, Britain's biggest home mortgage lender, were battered for a sixth consecutive day due to fears about its funding position.

ASIA PUMPING, RUSSIA SHAKING

Japan, Australia and India pumped $33 billion into money markets on Wednesday. Across Asia, which has so far been largely shielded from the worst of the credit crisis, central banks were bracing for more market turmoil.

The Bank of Korea said foreign funds would keep flowing out of the domestic bond market.

The Bank of Japan pumped 3 trillion yen (15.97 billion pounds) into the market in two moves, matching a record from March 31, after overnight rates jumped above 0.7 percent, 20 basis points higher than the central bank's target rate.

Bank of Korea Governor Lee Seong-tae said the credit crisis triggered last year by U.S. mortgage defaults would drag on and hurt the global economy: "We need to prepare for potential foreign fund outflow from the bond markets in the medium term."

Capital has been fleeing emerging markets as investors stung by the upheaval on Wall Street shun risky assets. Seoul has spent more than $30 billion this year to support the won, which has tumbled 17 percent in 2008 against the dollar.

Russia looked particularly fragile. Russian stocks plumbed new lows in the worst decline in at least a decade and the central bank injected a record 340 billion roubles of one-day funds in a Wednesday repo auction.

Trading on Russia's MICEX and RTS exchanges was suspended after their indexes tumbled 10 and 6 percent respectively on the day, reversing earlier gains and marking the biggest percentage fall for the MICEX index since the Russian financial system collapsed in 1998.

(Writing by Brian Love, with reporting by correspondents across Asia, Europe, Middle East and North America, editing by Swaha Pattanaik)