The dollar plumbed fresh lows and shares in Europe tumbled yesterday as investors fretted that strife in America’s sub-prime mortgage market could herald a wider credit crunch, which, in turn, would undercut US prospects.

In another turbulent day for global markets, rattled by Tuesday’s threat from Standard & Poor’s (S&P) to downgrade $12 billion of bonds backed by US sub-prime home loans, the dollar bore the brunt of investors’ anxiety.

The greenback slipped to a record low against the euro for the second day running, lifting the surging single currency to a high of $1.3787. The pound was propelled to a new, 26-year high, closing in London at $2.0343, having earlier hit a peak of $2.0351.

In Europe, shares were badly battered, with the FTSE 100 index and France’s benchmark CAC40 both shedding 0.3 per cent, while Germany’s DAX lost 0.8 per cent.

The losses came as Wall Street’s jitters over the riskiest sub-prime mortgage bonds persisted after S&P’s warning, sending the ABS derivative index used to track their value down still further from Tuesday’s record low.

In corporate credit markets in Europe, the iTraxx Crossover index of derivatives backed by mainly junk-rated corporate bonds, which gauges investors’ appetite for such debt, also leapt, indicating a jump in risk aversion. The iTraxx index is 50 per cent up from its level only a month ago.

However, blue-chip US shares recovered some poise after Tuesday’s steep sell-off, allowing the Dow Jones industrial average to rebound, adding 60 points by early afternoon in New York.The gains for US shares came as seemingly steadier nerves among American investors prompted them to abandon Tuesday’s abrupt retreat to the safe havens of Treasury bonds and gold, sending prices for benchmark US Treasury notes slipping back.

After initial price gains temporarily pushed the yield on ten-year Treasury notes to lows of 4.98 per cent, by late morning these had climbed back above 5 per cent as prices dropped.

The uncertain market action came as spooked investors struggled to get a clear fix on how fearful they should be about two separate, but closely linked dangers. The first is over a more broadly-based credit crunch; the second, that the housing market downturn in the United States could deepen and drag down the wider economy.

Anxiety over the risk of a credit crunch comes after years of lax lending by US instititions, encouraged by abundant, cheap credit created worldwide by past, very low interest rates. Now, with global interest rates sharply higher, this glut of easy money is drying up. The fear is that, as rates charged to borrowers rise, more of the loans too readily handed out in the past will turn bad, leading banks to impose much tougher conditions on new lending, slamming the brakes on corporate activity and the US economy.

The second worry, over the housing downturn, is closely tied to the first: were US house prices to fall more sharply, this could fuel still more mortgage defaults, triggering even greater tightening of credit conditions.

Fear of such a vicious circle was ratcheted up by the S&P warning over the value of bonds backed by high-risk, low-quality, sub-prime loans.

Yet economists remain confident that such worst-case scenarios will not materialise. Despite a warning yesterday from the National Association of Realtors that US home sales and prices will fall further this year than it previously thought, Charles Plosser, a senior Federal Reserve official, argued last night that this should not derail prospects for US growth to rebound.

Most economists agree with that view, despite edginess that incomplete understanding of the market in so-called CDOs (collateralised debt obligations), which slice up and parcel out loans across markets, makes diagnosing financial conditions in an accurate manner much harder.

Fresh bouts of turmoil remain likely until prospects become more certain. In Britain, the main impact of any such turbulence will be felt through falls in shares prices and further gains by a pound pushed up by a sliding dollar. A consolation is that such developments could help to forestall further, likely increases in interest rates here.

How US was caught out

What is the root cause of America’s mortgage woes?
The dramatic increase in high-risk home loans to people with poor credit ratings, known as sub-prime mortgages. As America’s housing boom defied gravity, mortgage lenders became ever bolder, lending to increasingly high-risk borrowers

Aren’t sub-prime mortgages only a small part of the market?
Sub-prime mortgages were fairly insignificant in 2001, accounting for $160 billion worth of American home loans that year, or 7 per cent of the total $2.2 trillion of mortgages. Last year $600 billion of sub-prime mortgages were agreed, one fifth of the $2.98 trillion total

What triggered the collapse?
The Federal Reserve raised its base interest rate 17 times between June 2004 and August 2006, from 1 per cent to 5.25 per cent. This fed through into dearer mortgages, at the same time as petrol prices were soaring and the economy was deteriorating. As a result, people found it harder to meet mortgage repayments

What does this mean for American homeowners?
Millions will see the value of their houses fall, leaving them with “negative equity”, meaning that their mortgage is higher than the value of their property. Hundreds of thousands will lose their homes altogether. Foreclosures, a legal process triggered by default that often leads to repossession, jumped 42 per cent in 2006 to 1.25 million. The trend has continued this year and foreclosures are expected to keep rising because repayments on adjustable sub-prime mortgages jump dramatically after the initial interest rate expires

What does it mean for everybody else? This has made it harder for people with “spotty” credit histories to get mortgages. Inside Mortgage Finance, the industry newsletter, predicts the volume of new sub-prime home loans will halve to $300 billion this year

What has been the impact outside the mortgage industry?
Hedge fund are losing a fortune because they have bought hundreds of billions of dollars of bonds backed by sub-prime mortgages, which are plummeting in value. Since hedge funds get most of their money from pension funds, retirement pots are also taking a drubbing. The cost of borrowing is rising as investors get increasingly nervous about lending

Have any UK firms taken a hit?
In addition to HSBC’s mortgage losses, Queen’s Walk Investment, the listed vehicle of the Cheyne Capital hedge fund, reported a plunge into the red for the year to March 31. Cambridge Place, the London fund manager, was forced to close its $908 million listed fund a day later. Barclays is likely to make a significant loss on the $300 million loan it made to one of Bear Stearns’s hedge funds

Where will it end?
Holders of mortgage-backed bonds can expect to lose tens of billions of dollars, while personal and corporate borrowers will have to pay more for loans. Brokers, lenders and ratings agencies will be on the receiving end of a flurry of lawsuits

Sources: Inside Mortgage Finance, Mortgage Bankers Association, Realtytrac

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