US, EU fight credit crunch

For the first time since 9/11, the Federal Reserve has had to step into the financial system with emergency funds to calm roiled credit markets.

The move Thursday followed an injection of capital into Europe's banking system. On both sides of the Atlantic, the central bankers began to recognize a crisis in confidence in the market known as asset-backed securitization, which funds everything from housing to student loans and has outstanding debt of more than $4.2 trillion. The banks' moves are seen as a signal that they're willing to provide liquidity to any bank that needs it.

By acting as lenders of last resort, the world's two largest central banks are trying to keep a liquidity crunch in this sector from spreading to the rest of their economies. If the crunch were to become more widespread, interest rates would rise and banks would have to pay more to fund loans, slowing the economy. In Europe already, interest rates skyrocketed to the highest level in six years after a major French bank froze three funds that had invested in asset-backed securities.

"It's a very significant event to have the Fed inject liquidity into the system," says Mark Zandi, chief economist at Moody's Economy.com. "It indicates a very high level of stress in the financial system."

The Fed acted because investors had stopped buying asset-backed securities following the difficulties in the US mortgage market.

The securitization industry, which involves financial institutions around the globe, provides liquidity that helps fund loans for housing, automobiles, credit cards, and student loans – and anything else where an asset can be bundled into a package and resold to other investors.

The crisis in the industry began to mount after the collapse of many mortgage lenders in the subprime market. That market makes loans to low-income people or those with less than stellar credit ratings. The crisis escalated after the collapse of American Home Mortgage, which was not in the subprime market. By early this week, buyers of overnight debt, which banks use to fund lending activity in the securitization market, had backed away. This caused BNP Paribas, a major French bank, to freeze withdrawals from three of its funds Thursday because it could not value the fund's assets.

The problems at BNP Paribas, a major European bank, caused the European Central Bank to inject $130.2 billion into the financial markets, according to Bloomberg News.

As the BNP problems suggest, sizable chunks of the risky mortgage securities are outside the US. "A lot of them were packaged and sold overseas," says Lacy Hunt, chief economist at Hoisington Investment Management Company, in Austin, Texas. "They were seeking higher yields."

On Thursday in Frankfurt, wire services reported, Germany’s central bank discussed the rescue of IKB Deutsche Industriebank AG, which was bailed out last month after it acknowledged large losses in the subprime mortgage market. However, the German financial services regulator told Dow Jones Newswires it does not see any need for a special audit of German banks to determine any financial liabilities.

The Fed's injection of funds – some $24 billion – came only two days after it decided to keep its policy on interest rates unchanged. In its statement Tuesday, the Fed noted that "credit conditions have become tighter for some households and businesses," but it did not mention a breakdown in the securitization market.

"A few days ago, it would have been advisable for the Fed to be more aggressive," says Mr. Zandi. "They are taking baby steps versus man-sized steps."

However, others felt the Fed took the right steps. "They're clearly vigilant. But are they sitting there with their finger on the panic button? We just don't think so," says James Sarni, a managing principal at Payden & Rygel in Los Angeles, which manages bond and money-market mutual funds.

In his press conference Thursday, President Bush tried to calm the markets. The fundamentals of the economy remain strong, he said. And, he added, "There is a lot of liquidity in our system. Liquidity will provide the capacity for our system to adjust."

The scope of the crisis began to dawn Thursday on Wall Street. The stock market closed sharply lower, with the Dow Jones Industrial Average losing 387 points.

"What caught everyone by surprise is the turbulence in the related hedge funds," says Fred Dickson, chief market strategist at D.A. Davidson in Lake Oswego, Ore. "In fact, it's been more of a shock factor than a surprise factor."

Mr. Dickson says the markets began to understand the severity of the problem on July 14, after the debt rating services downgraded $6.5 billion in subprime mortgages. Five days later, the Dow peaked at 14000.41. "After that, it was like a seismic shock and you could see the fear levels rising," he says.

Until Thursday, most economists thought the problem in the securitization market was isolated. "It looked kind of localized," says Scott Brown, chief economist at Raymond James & Associates in St. Petersburg, Fla. "Credit standards seemed to be a little bit tighter, but there didn't seem to be a credit crunch here."

But the Fed's actions, while calming the markets somewhat, have made stock traders realize they need to be alert, Mr. Brown says. "While no one thinks this will push the economy into a recession, there is a kind of nervous optimism," he says.