ECB Makes Unprecedented Infusion in Effort to Stem Credit Market Panic

The ECB made an unprecedented offer of unlimited funds to member banks as the demand for cash soared as a result of Paribas freezing redemptions of three funds. Mind you, these funds only had $2.2 billion of assets, far less than the troubled Bear hedge funds. The reaction seems disproportionate, unless you factor in that there are widespread rumors of other funds in distress, and not in strategies that have much to do with subprime (i.e., market neutral, statistical arbitrage, event driven).

In a bizarre way, this was predictable. The fact that Bush, the man who told us there were weapons of mass destruction and declared the mission in Iraq to be accomplished, said yesterday that the “solid” economy would weather the bad markets. Today, the ECB’s actions says that they see big-time systemic risk. Bush’s time to repudiation is getting shorter as he becomes more of a lame duck.

If the reports we are seeing of trouble at other hedge funds prove accurate, this is only the beginning phase of hedge fund liquidations (a reader pointed out that the Paribas funds were not hedge funds, but any credit market fund that loses 20% of its value in a mere two week was up to something pretty risky).

In addition, MarkeWatch tells us, citing Baring Asset Management, that $400 billion of unsold LBO debt is sitting on bank and investment bank balance sheets, which could clearly be placed only at a loss. That became worth even less with the spike up in rates today.

What firepower will the powers that be have left if they are already throwing cash at the markets?

From Bloomberg:

The European Central Bank, in an unprecedented response to a sudden demand for cash from banks roiled by the subprime mortgage collapse in the U.S., loaned 94.8 billion euros ($130 billion) to assuage a credit crunch.

The overnight rates banks charge each other to lend in dollars soared to the highest in six years within hours of the biggest French bank halting withdrawals from funds linked to U.S. subprime mortgages. The London interbank offered rate rose to 5.86 percent today from 5.35 percent and in euros jumped to 4.31 percent from 4.11 percent.

The ECB said it would provide unlimited cash as the fastest increase in overnight Libor since June 2004 signaled banks are reducing the supply of money just as investors retreat because of losses from the U.S. real-estate slump. Paris-based BNP Paribas SA halted withdrawals from three investment funds today because the French bank couldn’t value its holdings. Stocks in the U.S. and Europe fell, a turnaround from the past three days when investors concluded that credit market risks were abating.

“There seems to be a hole in the balance sheet of World Inc. that will have to be filled by government intervention,” said Peter Lynch, chairman of private equity fund Prime Active Capital Plc in Dublin. “The ECB is treating this like an emergency; it might make traders even more afraid.”

No Prices

The ECB said today it provided the largest amount ever in a single so-called “fine-tuning” operation, exceeding the 69.3 billion euros given on Sept. 12, 2001, the day after the terror attacks on New York.

The ECB’s decision, just one week after the German government arranged the bailout of IKB Deutsche Industriebank, is confirmation that the subprime debacle isn’t contained within the U.S.

BNP Paribas stopped investors withdrawing from funds with assets totaling 2 billion euros because it couldn’t find prices to value their holdings after the selloff in credit markets. Last week, BNP Chief Executive Officer Baudouin Prot said the bank’s U.S. subprime “exposure is absolutely negligible.”

“They simply don’t know what their assets are worth,” said Timothy Ghriskey, Chief Investment Officer of Solaris Asset Management in Bedford Hills, New York, which manages $1 billion of assets. “They can’t cash out their fund holders, and that’s the type of crisis that’s really based on panic.”

Federal Reserve

The U.S. Federal Reserve added $24 billion in temporary reserves to the banking system today, the most since April. Fed spokesman David Skidmore declined to comment on the increases in overnight money-market rates.

“Banks reacted to the ECB’s `sale’ offer in a similar way one would react to a sale in a department store” and “got all the money they could,” said Ulrich Karrasch, a money market trader at HVB Group in Munich.

The ECB intervention added to declines in stocks, with Europe’s Dow Jones Stoxx 600 Index falling 1.8 percent and the Standard & Poor’s 500 Index of U.S. shares down 2.1 percent to 1,466.64. U.S. Treasury notes gained for the first time in four days as investors sought the safest assets, cutting yields on two-year notes by 16 basis points, or 0.16 percentage point, to 4.50 percent.

The euro fell 0.8 percent to $1.3684. It dropped 1.9 percent versus the yen.

“The one downside to the ECB doing something is that it may suggest there are more issues out there,” said Barry Moran a euro-money market trader at the Bank of Ireland in Dublin. “People are nervous.”

`Extraordinarily Serious’

Credit-default swaps on the CDX North American Investment- Grade Index rose as much as 11 basis points to 71 basis points, according to Phoenix Partners Group in New York, reflecting an increase in the perceived risk of owning corporate bonds.

Three-month dollar Libor rose to 5.5 percent from 5.38 percent.

For Bank of America Corp., the No. 2 U.S. bank by assets, today’s increase in overnight borrowing costs is the biggest since the Federal Open Markets Committee raised interest rates at the end of June 2004. For UBS AG in Zurich, Europe’s No. 1 bank, it’s the largest jump since August 2004.

Both banks said their overnight borrowing costs rose 65 basis points to 6 percent. Royal Bank of Canada and Barclays Plc also said they would pay 6 percent.

“This is an old-fashioned credit crunch,” Chris Low, the chief economist at FTN Financial in New York, said in a report today. “This is not a small thing. A credit crunch, when the short-term credit markets seize up, is extraordinarily serious, almost always the precursor of a significant recession.”

Bear Stearns

The euro overnight deposit rate rose as high as 4.62 percent at 8:13 a.m. in London today before falling back to 4 percent by 1 p.m., according to data compiled by Bloomberg.

Bear Stearns triggered a decline in the credit markets in June after two of its hedge funds faltered, leaving investors with a near-total loss and forcing the New York firm to put up $1.6 billion in emergency funds to keep one of the funds from collapsing.

Default rates on home loans to people with poor credit, known as subprime mortgages, are at a 10-year high. American Home Mortgage Investment Corp. this week became the second- biggest U.S. home lender to file for bankruptcy this year, joining more than 70 mortgage companies that have had to close or seek buyers.

The credit crunch also tainted the market for corporate takeovers, as investors became increasingly wary of buying the high-yield bonds and leveraged loans that private equity firms used to finance deals.

Commercial Paper

“Somewhere out there, there are several people that are in trouble — it’s hard to put your finger on it,” said Andrew Busch, global foreign-exchange strategist at BMO Capital Markets in Chicago. “I cannot name names. We know BNP has issues with three funds. But you do not see a movement in overnight rates like that unless there is a huge concern about liquidity and funding.”

Companies are extending the maturity of existing short-term debt. Units of American Home Mortgage Investment, Luminent Mortgage Capital Inc., facing margin calls from lenders, and Aladdin Capital Management LLC this week exercised options allowing them to delay repaying debt, Moody’s Investors Service said.

The three companies borrow using short-term debt that is backed by assets, known as asset-backed commercial paper. They are probably the only companies to defer payments since extendible asset-backed commercial paper was first sold 12 years ago, according to New York-based Moody’s.

The average yield on U.S. asset-backed commercial paper rose 20 basis points to a six-year high of 5.56 percent today, the steepest one-day climb since September 2005.

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  1. Yves Smith


    Thanks for filling in the level of take-up by banks. This is ugly indeed. Panic has set in, and the financial bad news is far from over.

  2. Dave L

    So, what are the likeliest risks ahead? It seems to me that there must be a real threat to hedge (and other) funds of large-scale redemptions.

  3. burnside

    I note LIBOR is up. ARM resets are/will be affected.

    This will be my first experience of so many negative reinforcement loops simultaneously active.

  4. Yves Smith

    dave l,

    I wish I were smart enough to know the answer. Few would have expected that money market funds in Europe would be affected, Similarly, the FT pointed out on Monday that if one of the large credit insurers were to default, municipal bonds would be hit.

    Apparently the trouble today was caused at least in part by a big hedge fund liquidating positions (Goldman’s Global Alpha is the suspect) putting other funds into havoc.

    But I still think the real mechanism by which these financial market gyrations get into the real economy is the housing market. Banks and other creditors will be even more spooked after today’s events. Falling housing prices lead to negative wealth effect which leads to lower consumer confidence and spending. And per burnside, the fact that ARMs will go up doesn’t help.

    However, liquidity did dry up today. That is really surprising at this juncture (the credit contraction has really just gotten underway). The wild card is whether one or several investment banks eventually take enough credit-market-induced losses so as to impair their capital bases. The Bank of England sees that as having the potential to create systemic risk.

  5. dd

    Forcing a mark to market combined with resetting ARMs that impair households is creating a perfect storm. This resembles the Drexel junk bond collapse that spread to S&L; except it’s not a serial collapse but a real implosion. Agreed that we are just at the beginning as there is no mention of the always illiquid OTC derivatives and one can only imagine the fat tail contracts written for all those lovely fees that boosted bonuses with nary a dime toward reserves for events deemed too improbable to occur.

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