Cheap cash gets the credit for averting crash

Published on Sunday 19 August 2007 00:17

JUST after 8am New York time on Friday, thousands of pagers and mobile phones around the world bleeped into life and relayed the news - the crash might just be averted.

The US Federal Reserve's decision to slice half a percentage point off its discount interest rate was the first piece of positive news the markets had received in weeks. The fact that US Fed chairman Ben Bernanke had ordered the move through a rare telephone conference of commercial banks known as the Clearing House showed how deep the crisis had become.

Things arguably reached a low point on Thursday when Countrywide, America's biggest mortgage lender with 17% of the market, said it needed to use a 6bn bank line of credit as investors queued up to get their money out. The prospect that Countrywide was out of money sent shivers throughout the stock, bond and credit markets. This was not one of the notorious sub-prime lenders which had thrown billions of dollars at poor homeowners who had little chance of ever paying it back. This was the equivalent of HBOS in the UK.

As Countrywide admitted its problems, another senior banker, William Poole of the St Louis Fed, went on Bloomberg News to say there was no need for a rate cut - only a calamity would force the Fed to take action.

It appeared to be calamity enough for the US Fed, which ordered a cut to its discount rate - the interest rate it charges commercial banks to borrow money - early next morning. The move effectively makes cash cheaper and is intended to send out a signal that there is no need for individuals or institutions to hoard their money.

It sent the Dow Jones up 225 points and eased credit pressures, but was criticised by two separate camps. The first camp saw the cut as bailing out the reckless and feckless, a continuation of the rate cuts instigated by Bernanke's predecessor Alan Greenspan which some blame for creating the borrowing crisis in the first place.

Others wanted the Fed to go further and cut its main interest rate, citing the fact that only a tiny proportion of cash is borrowed on the discount rate.

Investors are worried about which big hedge fund or mortgage company will be the next to announce serious problems, so are scared to supply money through credit markets to companies.

Michael James, senior trader at investment bank Wedbush Morgan, says: "I don't think we've solved all the credit market problems with this move from the Fed. There's still just as much of a risk that the market could be down another 5% to 10% three months from now."

The so-called credit crunch and market turmoil have increased the chances of a recession, some economists believe, particularly as they start to affect consumer loans and credit card debt. There also is a fear that the credit crunch could harm business borrowing, forcing companies to scale back on their plans to expand their operations, resulting in job layoffs throughout the economy, not just in the construction industry, which has already been struggling with the slowdown in housing.

Bernanke's supporters insist that by calming the markets while leaving the more irresponsible lenders out in the cold, the Fed has got it right. Randall Forsyth of Barron's, the Chicago business bible, says: "Bernanke seems to have hit on just the right balance, and he's done it by reverting to traditional principles of central banking. Lending to the strapped borrowers through the discount window won't bail out hedge funds and other speculators, as would the much-desired cut in the Fed Funds target."

UK banks are less exposed to the sub-prime lending market but London stocks took their cue from New York last week, falling for days then recovering sharply when the Fed announced its discount rate cut.

Friday's gain of 3.5% lifted the FTSE 100 index above the psychologically important 6,000 barrier to 6064.2, recouping almost all of the losses seen on Thursday after credit fears had caused panic for stock markets worldwide.

Even mortgage lender Northern Rock, which had been hammered earlier in the week over fears about its reliance on wholesale credit markets, managed to recover most of the 10% its share price lost on Wednesday by the end of the week.

European markets were also cheered, with France's CAC 40 index rising 1.9% to 5,364 and Germany's DAX index up 1.5% to 7,378.

The Fed's move will almost certainly push the value of the dollar, already low by recent historical standards, even further down. "By no means is this positive to the dollar," said Gregory Salvaggio, a senior currency trader at Tempus Consulting in Washington. "This is the two-headed monster for the buck - lower interest rates and slower growth."

Only markets in Asia, which closed before the Fed move, finished lower on Friday than they had on Thursday. Japan's central bank injected 5bn into money markets on the day, the third injection last week and triple the amount it injected the day before, in a bid to curb rises in key interest rates. The lower US currency hurts Japanese exporters by reducing the value of their overseas earnings when converted back into yen. The Nikkei 225 index in Tokyo crashed 5.4% to end at its lowest close in a year.