Fears in the credit markets

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THIS week, while global stockmarkets appeared to be regaining some confidence after their July rout, a new problem was bubbling quietly up in an obscure corner of the credit markets. It burst into the open on Thursday August 9th when the European Central Bank (ECB), responding to a sudden liquidity squeeze and a spike in the interbank lending rate, injected €94.8 billion ($131 billion) into the money markets. In a bigger special refinancing operation than that of the day after September 11th 2001, the ECB in effect assured European banks that they could borrow from it whatever they needed to address their short-term cash needs. Immediately, the pressure on overnight interest rates eased, but not before stockmarkets once again started to dive, gripped by a resurgence of fears about the fallout from America’s subprime-mortgage crisis.

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The catalysts for the latest sell-off were just the sort of “Frankenstein-finance” vehicles that have come to haunt the markets lately. They are complex, held off the banks’ balance sheets and pop up in surprising parts of the world—the most troublesome to date has been that of IKB Deutsche Industriebank, a small German lender which has required a messy bail-out by German banks. Known as conduits, these special-purpose vehicles borrow in the short-term, commercial-paper market to make acquisitions of highly rated paper in American asset-backed securities, and have been walloped by the plunging value of those assets since the frailty of subprime loans were exposed.

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The lenders, who provide funding to them for up to nine months, have increasingly, as the week draws on, demanded higher fees to roll over their commercial paper, analysts say. Since Wednesday it appears that a sense of panic has started to grip the market, and borrowers scrambled for liquidity. “It went much broader than the asset-backed market. People were using expressions like ‘the market has shut down’,” commented a senior economist at a big global bank.

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Whether a casualty of the liquidity crisis, or a catalyst, an investment arm of BNP Paribas, France’s biggest bank, added fuel to the fire on Thursday by suspending withdrawals from three investment funds, citing “the complete evaporation of liquidity in certain market segments of the US securitisation market”. Following IKB’s much publicised problems, investors have begun to worry about where else such problems are likely to crop up. Analysts say the conduits are quite widely used by many of the world’s largest banks, and some may be more creditworthy than others. But in the current climate of fear, any bank that seeks to roll over its short-term funding can look like it is doing so out of desperation—the textbook problem of adverse selection.

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The ECB’s move eased the cash crunch—at least temporarily. Overnight rates dropped back to the central bank’s target rate of 4%, and economists praised the speed and effectiveness of its intervention. However, the provision of liquidity is only a short-term measure to restore calm. Even cuts in interest rates, which financial markets are pricing in increasingly aggressively, would not necessarily address the underlying problem. Restoring faith in American mortgage markets, and the cornucopia of investments derived from them, is the bigger challenge. To do that, many had hoped this week that Fannie Mae and Freddie Mac, America’s two governement-sponsored mortgage giants, could step in and mop up some of the subprime loans that the private sector is too fearful to buy. But President George Bush appeared to dismiss such a response on August 8th, which may be another reason why the markets so suddenly lost their nerves once again.