Anyone who thought the subprime mortgage crisis was a problem for the markets and moneymen who created the mess had that bit of sophistry destroyed last night when European money markets nearly froze, forcing the European Central Bank to pump in more than $A150 billion of emergency funds to free up liquidity.

The ECB offered unlimited cash to borrowers at its main lending rate of 4% after overnight rates rose sharply past that level, causing concern and growing fear of a credit crunch in Europe.

And the US Federal Reserve did its bit, advancing by a few minutes its daily injection of funds into US money markets to make sure there was no liquidity lock up and ease a credit squeeze that had appeared overnight in the huge (and usually very liquid) commercial paper market.

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In Sydney The Reserve Bank said it proceeded with its normal money market operations today.

The US Federal Reserve meanwhile injected around $A27 billion, the most since April and appeared to time it to coincide with the ECB’s move.

This was after overnight the rates banks charge each other to lend in dollars soared to the highest in six years in Europe, while rates on the commercial paper market in the US escalated by similar levels.

Both happened within hours of France’s biggest bank, BNP Paribas, stopping withdrawals from three funds linked to subprime mortgages. The funds had around $US2.2 billion invested but what was frightening about the move was, firstly the commentary by the bank that liquidity had evaporated and secondly, only a week ago the CEO of the bank had said its exposure to subprime mortgages was “absolutely negligible”.

Obviously he and the bank had no idea.

Famous last words, but they were enough to spook the entire European interbank market: The London interbank’s offered rate rose to 5.86% from 5.35% and in euros jumped to 4.31% from 4.11%

But some banks found it hard to borrow at all without paying 6% or more.

The ECB at first noted the sharp rise in rates, and then announced the emergency funding.

Brokers and media reports said it was 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 came a week after the German government arranged the bailout of IKB Deutsche Industriebank, which had total obligations of a very scary $US24 billion and could lose more than $A1.2 billion of an emergency credit line of $A5 billion..

The intervention by the ECB raised concerns that there might be more problems among European financial institutions.

BOP joined Bear Stearns Cos. and Union Investment Management of Germany in stopping fund redemptions. Dutch investment bank NIBC Holding NV said yesterday that it lost at least $US188 million on subprime investments this year.

So far it seems the more surprising losses have been taken in Europe.

Besides BNP and IKB, Axa, the big French insurer, is offering up to $A1.2 billion to bail out investors in two funds that have subprime exposure; several other German banks and investors have exposures of up to $US500 million or more, based on values established a week or so ago.

There have been further falls in the value of the securities based on subprime mortgages; a big London based hedge fund, Caliber has closed and attempting to trade itself down to repay investors with more than $US900 million invested, and another UK fund, Cheyne Walk has owned up to losses of $US91 million.

(In Australia we have three funds with losses of probably around $A1 billion. But that is contingent on no further falls in asset prices and being able to trade out of the problems. Conditions have worsened since Basis, Absolute and Macquarie Fortress revealed their problems)

European media reports said BNP followed Union Investment Management GmbH and Frankfurt Trust in stopping redemptions from such funds. Union Investment, is Germany’s third-biggest mutual fund manager. It has stopped redemptions from one of its funds last Friday after investors pulled around 10% of the assets. Frankfurt Trust, the mutual fund manager of Germany’s BHF-Bank, stopped withdrawals from a fund after clients pulled 20% this month.

According to Bloomberg, “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.

“Overnight borrowing costs rose 65 basis points to 6 percent for both banks, according to prices provided to the British Bankers’ Association. 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.”

The average yield on American asset-backed commercial paper rose 20 basis points to a six-year high of 5.56%. That was the biggest one-day rise in almost two years.

Meanwhile those rumours about big US investment bank backed hedge funds won’t go away. Some are reported to be in trouble, others are facing falling values. Rumours that one big Goldman Sachs fund would close frightened markets Wednesday morning, but the story was denied.

But amid the plunge overnight in Wall Street came reports in US business media that the funds and one from Hedge funds that use mathematical models to make investment decisions, including those run by Highbridge Capital Management (associated by JPMorgan), Goldman Sachs Group and Tykhe Capital, are losing money in August.

The reports said Highbridge’s $US15 billion multistrategy fund fell 4%, the Tykhe Portfolios Ltd. Fund declined 7% in the first three trading days of August and Goldman Sachs’s $US9 billion Global Alpha fund dropped almost 12% in the two weeks ending last Friday. A second Goldman fund was reported to be selling positions in response to losses.

Other big hedge funds have lost ground in the past two weeks, others are being closed.

According to Marketwatch.com Black Mesa Capital, a Santa Fe, New Mexico-based quant hedge-fund firm is liquidating trading portfolios at one of its funds it manages. Black Mesa’s own fund has slumped 7.5% so far this month.

BNP Paribas’s statement summed up the situation nicely, and sort of explained why the ECB and the Fed did what they did: “The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly regardless of their quality or credit rating.”

That says no-one knows.

And when the likes of Bank of America, UBS (which has lost hundreds of millions of dollars in subprime plays in its US hedge funds owned by its Dillon Read investment banking arm), Barclays, RBS, Deutsche Bank, can’t borrow normally because markets are spooked by just $US2.2 billion in distressed assets held in funds run by France’s biggest bank, we know the subprime mess is no longer just the concern of the moneymen and their mates.

The money is there, but no one would lend it without asking some of the highest-rated banks in the world to pay junk bond prices for overnight money.

It’s become everyone’s concern. For liquidity to vanish so quickly in the second largest set of financial markets in the world shows how fearful banks and other investors have become. Trust has gone out the door and no one can get it back.

And, today The Bank of Japan added 1 trillion yen in $US8.50 billion to the Japanese financial system, joining central banks in the U.S and Europe in supplying cash to ease fears of a credit crunch.

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Peter Fray
Peter Fray
Editor-in-chief of Crikey
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