Panic grips credit markets

By Krishna Guha in Washington, Michael Mackenzie in New York and Gillian Tett in London
Published: September 17 2008 18:23 | Last updated: September 17 2008 22:39

Panic in world credit markets reached historic intensity on Wednesday, prompting a flight to safety of the kind not seen since the second world war.

Barometers of financial stress hit peaks across the world. Yields on short-term US Treasuries reached their lowest level since the London Blitz. Lending between banks in effect halted and investors scrambled to pull their funding from any institution or sector whose future had been called into doubt.

The turbulence claimed another British victim in HBOS. The largest mortgage lender is to be taken over by Lloyds TSB in a £12bn deal after the government pressed it into talks having seen its share price halve this week.

The $85bn emergency Federal Reserve loan for AIG, the troubled insurance group, announced on Tuesday night, failed to curb the surge in risk aversion. Instead, markets were hit by a fresh wave of anxiety.

Speculation mounted that the Federal Reserve, which refused to cut rates on Tuesday, could be forced into an embarrassing U-turn. Amid the chaos, traders were pricing in 32 basis points of rate cuts by the end of the month – in essence betting that there was a 60 per cent chance the Fed would cut rates by half a percentage point in coming days.

One cause for fear came when shares in a supposedly safe money market mutual fund fell below par value because of losses on Lehman Brothers debt. This raised the risk that retail investors in other such funds could panic and pull out their money.

All thought of profit faded as traders piled in to the safety of short-term Treasuries. The yield on three-month bills fell as low as 0.02 per cent – rates that characterised the “lost decade” in Japan. The last time they were this low was January 1941.

Shares in the two largest independent US investment banks left standing – Morgan Stanley and Goldman Sachs – fell 24 per cent and 13.9 per cent respectively as the cost of insuring their debt soared, threatening their ability to finance themselves in the market.

The falls in financial stocks have prompted a wave of merger talks. People close to the situation said on Wednesday that Morgan Stanley was holding preliminary merger talks with Wachovia, the troubled regional lender. Washington Mutual, another regional lender, has hired Goldman Sachs to contact potential buyers including JPMorgan Chase, Citigroup and Wells Fargo.

Lending between banks in Europe and the US in effect halted. The so-called Ted spread – the difference between three-month Libor and Treasury bill rates, which measures fear over banks – moved above 3 per cent, higher than the record close after the Black Monday crash of 1987.

US authorities fired back. The Treasury announced it would borrow money to give to the Fed for its emergency lending operations – in essence removing any balance sheet constraint on the size of this assistance.

The Securities and Exchange Commission announced curbs on short-selling that traders called draconian. Short-sellers, who profit from share price declines, were widely blamed for AIG’s troubles. But the efforts failed to avert heavy selling, particularly of US financial stocks.

Traders blamed the Fed for not cutting interest rates amid speculation that the US central bank could be forced into a U-turn. Many analysts also criticised the US authorities for adopting an arbitrary approach to rescues – saving AIG but not Lehman – that failed to boost confidence.

The S&P 500 fell 4.7 per cent, led by a 8.9 per cent slump in financials. Equity volatility was near its highest level since March. Gold benefited, with bullion prices leaping 11.2 per cent to a three-week high of $866.47 a troy ounce. Andrew Brenner, co-head of structured products and emerging markets at MF Global, said: “It feels like no one wants to take anyone’s credit . . . It feels like we are on a precipice.”

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