From their position high in the Eurotower, the skyscraper headquarters of the
European Central Bank (ECB) in the heart of Frankfurt, staff keep a close
eye on what is happening in the money markets around Europe. On Thursday,
the market-operations division noticed that something very unusual was going
on. Liquidity appeared to have dried up, and interest rates were soaring.
The market meltdown, triggered by an announcement in Paris from BNP Paribas
that it was halting redemptions on three funds linked to American sub-prime
loans, was further evidence that America’s mortgage crisis had spread around
the world.
What the ECB did, according to Thomas Mayer, chief economist at Deutsche Bank,
was straight out of the textbook. The central bank, which might have been
expected to be uncomfortable about acting to ease a crisis prompted by lax
lending in America, came in with all guns blazing.
“The ECB correctly identified the situation in the money market as a loss of
trust,” he said. “And when there is no trust there is no credit.”
By Thursday evening, Europe’s central bank had pumped in €95 billion
(£64 billion) of liquidity into the markets. On Friday it provided a further
€61 billion, making more than £100 billion in two days. This was more than
the ECB provided to the markets in the wake of the September 11 terrorist
attacks.
In America, the Federal Reserve also stepped in, providing nearly $60 billion
(£30 billion) of liquidity over two days. Other central banks, including the
Bank of Japan and Reserve Bank of Australia, waded in. But the Bank of
England, despite a sharp rise in overnight interest rates in London, decided
to stand back. Money-market sources said the Bank regarded its facilities
for the money markets as adequate.
Central banks only intervene to provide liquidity in extreme conditions, and
last week there were extreme conditions in financial markets across the
globe. Shares, which have yo-yoed in the face of the news from credit
markets panicked by defaults in America’s sub-prime loans, suddenly got the
jitters.
“The past couple of days have felt different,” said the boss of one London
broker. “There has been real distress selling. Whether it’s hedge funds
facing redemptions or people trying to cover their margins, I don’t know. It
is the first time we have seen selling like this since the start of the
current bull run in 2003.”
The FTSE 100 bore the brunt, including a drop of more than 230 points on
Friday for a two-day fall of 350 points, or nearly 6%, to 6,038.3.
“It’s a complete bloodbath,” said one trader. “I can’t tell you how bad it is.
This boom hasn’t really been caused by India or China or anything
substantial; it’s a massive amount of money and debt and deals that have
grown out of nowhere. In 2002, you couldn’t borrow a penny, but recently no
amount has been too big. Now we’re worried that, since the money appeared as
if by magic, it can disappear like magic too.”
Not so long ago, stock-market pundits were predicting that the FTSE 100 index
was about to rise above 7,000. Now a struggle is on to keep it from falling
below 6,000.
FEAR of the unknown is the biggest fear of all, and that is what is gripping
the markets. Nobody knows how big the losses are in America’s sub-prime
market and, more importantly, on CDOs (collateralised debt obligations),
into which some of the sub-prime debt was sliced and diced, and other
complex financial instruments.
“What has changed is that people close to derivative-trading desks are now
talking about the potential for a massive unwinding of geared funds,” said
Etienne Varloot, credit strategist at UBS. “We don’t think that is going to
happen, but the fact that people are talking about it is sufficient to
increase volatility. Credit spreads have moved up about 80 basis points. For
there to be a major collapse, that would have to double at least.” Last
weekend Warren Spector, co-president of Bear Stearns, the Wall Street firm,
was forced to resign over the housing-related failure of two of its hedge
funds. The markets had taken the view that the “contagion” from the
sub-prime crisis was largely confined to America. Paribas’s announcement on
Thursday opened up a new source of worry. If the contagion was spreading to
European banks, where would it end?
There was trouble in Germany, too. Two weeks ago Stefan Ortseifen, chief
executive of IKB Deutsche Industriebank, a German bank specialising in loans
to smaller companies, reassured investors that the bank was clear from the
dangers of the sub-prime fallout. He seemed to have every right to be
confident; the bank had only a small amount of sub-prime debt on its balance
sheet.
But last week, IKB was bailed out, receiving a cash injection of €3.5 billion
from its biggest shareholder, the state-owned KfW bank. On Thursday,
Germany’s Bundesbank called an emergency meeting to discuss IKB; on Friday
German prosecutors announced an investigation into its business dealings.
One analyst said: “It’s an extraordinary thing that one minute the bank is
fine, the next it is being bailed out using taxpayers’ money.” Meanwhile,
concerns were mounting over other German banks.
The focus, however, may switch back to America. Rumours abound of “another
Drexel”, recalling the 1990 collapse of Drexel Burnham Lambert, Wall
Street’s biggest ever bankruptcy. The rumours point to a leading investment
bank sitting on tens of billions of dollars of losses as a result of the
sub-prime crisis and the shake-out in credit markets. But the potential for
problems is spread through the banking system.
“At the moment, we simply don’t know what may be out there,” said Ian Richards
at ABN Amro. “The market is clearly fearful of major problems, but we simply
don’t know how material the effect might be on any particular bank.”
Pilar Gomez-Bravo at Lehman Brothers Asset Management said: “The concern is
that it is almost impossible to measure the scale of the problem. One factor
is that only a third of hedge funds have reported their performance for
July. Until there is more clarity around, there is likely to remain a lack
of liquidity. The big question is whether a meltdown will in a sense become
a self-fulfilling prophecy.”The fear among bankers is that the days of the
big deal, made possible by easy credit, are over. Most, however, believe
that something will be salvaged from the wreckage.
Banks that underwrote the KKR buyout of Alliance Boots have been struggling to
syndicate the debt. They have just managed to syndicate the most junior
tranches, but only at 95p in the pound. This was enough to wipe out their
arranging fees for the entire deal.
“As the Alliance Boots deal shows, it is difficult to get large and
aggressively structured deals away,” said one trader. “But smaller deals are
getting done. Lenders have not completely closed their doors.”
Simon Mackenzie Smith at Merrill Lynch agrees. “There is a danger that this
will spill over into the wider economy, but I don’t think it will unless the
banks start taking a very negative attitude to risk,” he said.
“To all intents and purposes the large-scale leveraged buyout market is shut
for now, but financial sponsors will just focus on deals that are smaller
and more doable,”
THE big question is what happens next, and whether central banks will have to
do more than just provide liquidity to the markets.
One of the most-watched clips on You Tube, the internet site, is of Jim
Cramer, the star of financial channel CNBC. He has described the markets as
“armageddon” and lambasted Ben Bernanke, head of the Federal Reserve Board.
“We have thousands of people losing their homes . . . this is not the time
to be complacent,” he said.
Others are less colourful in their language but believe that interest rates
should be cut. Ed Yardeni of Yardeni Research said: “There are too many
innocent bystanders for the Fed to stand by and punish those who got us into
this mess.”
Ken Goldstein, economist at The Conference Board, a New York think-tank, said: “One
of the things that we need now from Bernanke or from [Bank of England
governor] Mervyn King is for them not to overreact and never to panic.
Should Bernanke make a speech? Yes.
Should he cut rates? No.”
Goldstein said the impact of sub-prime loans on the housing market had been
over-played and a lot of “nervous Nellies” were panicking but the economy in
general was holding up. “If Bernanke were to cut rates, he might feed the
panic,” he said.
According to Deutsche’s Mayer, the ECB’s plan for a rate hike from 4% to
4.25%, which it signalled ear-lier this month, is now in doubt. “If this
should blow over, the ECB will still act. But the odds on the ECB delivering
on its signal must be somewhat lower now,” he said.
The Bank of England, which on Wednesday published its inflation report
pointing to a further rate rise, is still concerned about the strength of
the economy and above-target inflation (see related link in panel, left).
Some of its members will be uneasy about raising rates while the market
turmoil persists, and until its full effects have been assessed. At the very
least, the crisis may have bought borrowers some time.
Time is a commodity that some in the financial markets do not have this
weekend. “There are thousands of hedge funds and so far we have seen some
serious problems,” said Mike Lenhoff at Brewin Dolphin. “It could be the tip
of the iceberg.”
