FYI | Aug 10 2007
By Greg Peel
Just as a meeting was underway at Germany’s Bundesbank, planned to discuss the rescue package for Dusseldorf-based small company lender IKB, news came across the wire that France’s biggest bank – BNP Paribas – had just frozen redemptions from three of its high-yield hedge funds. While the funds only represent about 1.6 billion euros as against the bank’s 600 billion euros under management, investment in US subprime mortgage securities had led the funds into a position where there was no choice but to freeze.
A spokesperson for BNP told the New York Times that the credit squeeze underway in the US had made it impossible to calculate the value of the underlying assets of the funds and that the bank was obliged by market conditions to halt holders of the funds from cashing out or new investors from buying shares in the funds. It was quite an exceptional move, the spokesperson admitted, but BNP hopes it’s only temporary.
The announcement sent Wall Street into a tailspin in early trade, but soon some calm was restored. The stock market bulls had decided earlier this week that while there would no doubt be more hedge funds announcing freezes or closures due to the subprime fallout, financial sector shares had already taken that hit. Values were now attractive, and this was a great buying opportunity. The Dow bounced back once more.
But by lunchtime, the mood had changed entirely.
Traders from Wall Street to The City were astounded to learn that the European Central Bank had taken the astonishing step of offering European banks as much as they wanted in the form of funds in order to head off the spiralling liquidity crisis. With US mortgage securities held all over Europe and no way of knowing just how many and whether they are worth anything at all, European banks had suddenly become very suspicious of each other. In a typical banker’s day money will be constantly lent and borrowed between banks and financial institutions as they go about their business. If suddenly no one will lend to anyone, liquidity is frozen and the whole system faces collapse.
This is exactly one reason why central banks exist – to ensure liquidity in the banking system. When a central bank “raises” or “lowers” the cash rate, all it is actually doing is indicating the rate at which it would like to see daily business being transacted. If there is deemed to be too much money in the system, risking runaway economic growth and inflation, the bank will raise its preferred target. The higher the cost of money, the more business will slow. And the same works in reverse. The ECB had recently raised its target rate to 4.0%.
In order to ensure borrowing and lending is actually transacted at the target rate, a central bank will conduct what are known as “open market operations”. Daily the bank will either inject its own reserves into the system, or pull money out. Such moves are required when the rates move incrementally above or below the target rate. Usually such operations are orderly and of little consequence. Various banks will go to the central bank “window” and deal directly with the central bank rather than a competitor. The central bank is thus the “lender of the last resort”.
The ECB has never before, in its existence, said “how much do you want”. As soon as the word went out, 49 banks had lined up at the window. They extracted a total of 94.8 billion euros. The only other time the ECB has made such a large injection was the day after 9/11. But in that case it only injected 69 billion euros. While daily fluctuations away from the target cash rate are normally very marginal, rates yesterday had reached a full 68 basis points above the target. A liquidity squeeze was underway. This was enough for the ECB to open the vault.
This was the news that really spooked Wall Street, sending the stock markets tumbling wildly and closing on their lows. The only extra bit of news had been the BNP hedge fund closures, and in the scheme of things, it was all pretty minor. But if the ECB had taken such an extraordinary step, what does it know that the markets don’t? To just what extent has the world been plunged into a liquidity crisis?
And will it solve the problem? Not according to ABN Amro’s head of global money markets, who told the Financial Times:
“The underlying problem cannot be addressed directly by the ECB and therefore we will see the same liquidity difficulties tomorrow and the next day.”
But not all European central bankers are thrilled with the ECB’s actions. One ECB official told the FT:
“The aggregate liquidity conditions are usual even if there is a bit of turbulence. But there is the risk that banks may not really have needed this amount of liquidity and that the market therefore reads something into this action that they shouldn’t do.”
Whatever the consequences, the central banks of the world have started to go down a similar path to the ECB, albeit in nothing like the amount. The New York Federal Reserve injected US$24 billion into the system – twice the normal daily average. But in an unusual move, the NY Fed opened its window fifteen minutes earlier than usual. While president Bush called a hasty press conference to assure Americans there was plenty of liquidity in the system, the Fed remained silent. Given Ben Bernanke had only two days earlier kept the cash rate steady, and suggested intervention would not be necessary, it is apparent the Fed is not about to go into full crisis-fighting mode.
The Bank of Japan injected US$8.5 billion into its system yesterday. Analysts are now suggesting that an increase to Japan’s current 0.5% cash rate that was largely expected this month may not happen. Already the yen has appreciated markedly against the US dollar as carry trade unwinding moves into a second phase.
The Reserve Bank of Australia also added twice its usual amount of funds into its system this morning, or close to A$5 billion. Treasurer Peter Costello again pushed the line that Australia had minimal exposure to the US subprime mortgage market. While this may well be the case, it hasn’t stopped credit securities everywhere being impossible to sell, and for credit spreads to widen even in prime paper. There is a reason the Australian stock market is down 2.5% in mid-afternoon trade.
The dust surrounding the subprime mortgage crisis will one day settle. That day will not come anytime soon. Its legacy will be a return to “normal” credit spreads, which effectively means a higher cost of borrowing and of servicing debt for all corporations and individuals alike. While most economists are so far not expecting such, there is a clear and present danger the US economy will tip into recession, slowing the global economy. Nor were economists expecting the ECB’s response last night either.
There is a possibility that in order to subvert further spiralling defaults in US mortgages – the root of the problem – the US government will lift the “investment cap” on the two government-sponsored mortgage lenders, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Home Loan Mortgage Corporation (Freddie Mac). Neither of these institutions have been permitted to date to participate in subprime lending, but the rules may now be changed in an attempt to provide some sort of rescue package for delinquent US mortgage holders. Unfortunately, these organisations have recently been embroiled in investigations into fraud, and may come across as rather suspicious white knights. They are, after all, both listed companies. The President had earlier indicated the government was not going to intervene in the crisis, but now it remains to be seen.
