US, EU fight credit crunch

Emergency funding aims to keep subprime woes from spreading.

By Ron Scherer | Staff writer of The Christian Science Monitor

from the August 10, 2007 edition

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New York - 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."

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