[R-G] Worldwide market panic compels central banks to intervene

[Anthony Fenton]

WSWS : News & Analysis : World Economy
Worldwide market panic compels central banks to intervene
By Patrick Martin
13 August 2007

http://www.wsws.org/articles/2007/aug2007/mark-a13.shtml

The world financial system remained on a precipice over the weekend,  
awaiting the opening of markets Monday, after central banks in  
Europe, the United States, Japan and several other Asian countries  
were compelled to intervene Thursday and Friday with massive  
commitments of funds to stave off a global panic.

A total of $323 billion was poured into the markets over two days, an  
injection equivalent to that carried out in the aftermath of the  
terrorist attacks of September 11, 2001. The bailout came too late to  
stem the fall in Asian and European markets, but the New York Stock  
Exchange rallied after a fall of nearly 200 points, with the Dow  
Jones average ending 31 points down. For the week, the US market was  
virtually unchanged after a series of colossal moves up and down,  
including Thursday’s plunge of 387 points.

European and Asian markets ended Friday’s trading down between 2 and  
4 percent before the second round of support from the European  
Central Bank (ECB) and the US Federal Reserve. The FTSE index of  
London stocks dropped 3.7 percent, the French CAC index fell 3.1  
percent, while Germany’s DAX declined 1.5 percent. Japan’s Economy  
Minster Hiroko Ota told reporters, “The effect of US subprime loans  
is spreading to financial markets around the world.”

The ECB and the Fed had to intervene Friday as it became clear that  
Thursday’s actions had failed to stem the rout. The ECB followed  
Thursday’s $130 billion in loans with an additional $84 billion,  
while the Fed injected $38 billion on top of Thursday’s $24 billion  
worth of support.

Friday’s Fed intervention came in three stages—$19 billion in the  
morning, $16 billion more in the early afternoon, and $3 billion  
towards the end of the trading day, indicating that the central bank  
was gauging the effect of its actions hour by hour and reinforcing  
its support when the market began to give way again.

While the sums expended by the central banks were far larger than  
their everyday operations, the amounts are small compared to the  
scale of world financial markets—an estimated $175 trillion in  
stocks, bonds and other debt instruments—and the trillions in paper  
value already wiped out in the convulsions of the past several weeks.

The events of Thursday and Friday demonstrate that, despite the  
common desire to forestall a chain reaction collapse of the world  
financial system, the various central banks have differing and in  
some cases directly conflicting agendas based on disparate national  
policies and concerns.

The European Central Bank, for example, pumped more than three times  
as much into the financial system as the US Federal Reserve, although  
European and American markets are approximately the same size and the  
immediate focus of the financial crisis is in the United States, with  
the collapse of the market for securities based on subprime mortgages.

The major concern in Frankfurt was the shaky state of confidence in  
the continent’s banking system, with the state-organized bailout of  
the German IKB Deutsche Industriebank followed by the announcement by  
BNP Paribas, the biggest publicly held French bank, that it was  
suspending redemptions from three of its hedge funds caught up in the  
US mortgage market crisis.

The IKB crisis was a direct product of the American mortgage-lending  
debacle, as the regional bank, specializing in lending to small and  
medium companies, had become deeply committed to the US property  
market. Der Spiegel magazine reported Friday that IKB and its  
affiliates had more than $10 billion in loans to the US mortgage  
sector, twice the previous estimate, including nearly $8 billion  
invested by Rhineland Funding Capital Corporation, which is managed  
by the bank.

The German government and the national central bank, the Bundesbank,  
organized a bailout of IKB, with credits totaling nearly $10 billion  
routed through the state-owned KfW bank, which owns the majority of  
the shares in IKB. Prosecutors in the Ruhr capital of Düsseldorf have  
begun a criminal investigation into IKB’s operations, and the bank’s  
chief financial officer resigned August 7, eight days after CEO  
Stefan Ortseifen.

The biggest German private bank, Deutsche Bank, announced Friday that  
the value of its DWS ABS investment fund fell 30 percent, although it  
did not follow the example of BNP Paribas in suspending redemptions.  
Ominously, the bank said that the American subprime mortgage crash  
was not the immediate cause of the losses, but affected the fund  
indirectly because “The uncertainties surrounding the US mortgage  
crisis has constricted liquidity.”

While the European Central Bank intervened massively, the Bank of  
England, by contrast, did nothing Thursday or Friday. It was the only  
one of the world’s major central banks to offer no support to the  
financial markets. The Japanese central bank offered relatively  
minimal support, about $8 billion, while central banks in smaller  
countries like Canada and Australia mustered greater support in  
proportion to their own resources.

The role of China, whose central bank has accumulated assets of over  
$1.1 trillion, is potentially critical in this crisis, and there was  
widespread consternation and comment in financial circles after the  
British newspaper Daily Telegraph published a report August 8 that  
the Chinese government “has begun a concerted campaign of economic  
threats against the United States,” and was hinting that it might  
liquidate its holdings of US Treasury notes if Washington imposed  
trade sanctions, as demanded by Democratic congressional leaders and  
presidential candidates.

A Chinese central bank official issued a statement declaring, “US  
dollar assets, including American government bonds, are an important  
component of China’s foreign exchange reserves as the dollar enjoys a  
major position in the international monetary system based on the  
large capacity and high liquidity of US financial markets.” That such  
a statement had to be issued at all is extraordinary. Moreover, it  
suggested a more modest role for the US dollar, failing to refer to  
it as the major world reserve currency.

In the United States, the Federal Reserve’s public posture has been  
to downplay the seriousness of the crisis. The Fed’s board of  
governors met Tuesday and decided to leave interest rates unchanged,  
issuing a statement reiterating that inflation rather than financial  
instability was still the main danger to the US economy.

On Thursday, the Fed belatedly pumped $24 billion into the financial  
system as the New York Stock Exchange was plunging. On Friday  
morning, after Asian and European markets had plunged further, the  
Fed began further efforts to increase liquidity and issued a  
statement that it “is providing liquidity to facilitate the orderly  
functioning of financial markets.”

In a highly unusual move, the entire $38 billion the Fed expended  
Friday was directed to purchasing mortgage-backed securities, which  
might otherwise have gone without buyers. The two-day total of $62  
billion compares to a daily average of $75 billion during the week  
after the September 11, 2001 terrorist attacks.

Despite the brief respite in the stock market rout Friday afternoon,  
the full impact of the crisis in US mortgage-based securities is  
still to be felt. Two large home mortgage firms, Countrywide  
Financial, the largest, and Washington Mutual filed declarations  
Thursday night with regulatory agencies that they were having  
difficulty funding new home loans. The stock price of both companies  
fell precipitously Friday.

Another large home lender, HomeBanc of Atlanta, Georgia, filed for  
bankruptcy Friday, showing debts of $4.9 billion. Its creditors  
included both a long list of American financial institutions—the  
largest being Fidelity, the biggest mutual fund—and such European  
banks as the German Commerzbank, the French BNP Paribas and the Dutch- 
based Fortis.

“Recent disruptions in the mortgage loan and real estate markets have  
been dramatic, in terms of both magnitude and timing,” CEO Kevin Race  
said in a statement. HomeBanc was now in an “untenable business  
position” and would seek “an orderly wind-down of the company.”

Wall Street financial markets have become indissolubly linked to the  
financing of home mortgages in the last eight years, as the process  
of “securitization” of mortgages has become widespread. Mortgage  
lenders no longer hold mortgages to maturity, collecting monthly  
payments. Instead, they sell the mortgages to the huge federally  
backed mortgage repackaging companies, Fannie Mae and Freddie Mac, or  
directly to hedge funds and other financial institutions. In 2006,  
Wall Street firms issued $773 billion in mortgage-related securities,  
according the Securities Industry and Financial Markets Association,  
up from $217 billion in 2001.

The subprime market accounts for about $2.5 trillion in lending, much  
of which is expected to go into default in the next six months. About  
ten percent of all subprime borrowers are already behind on their  
payments, with $212 billion in loans in default through May and  
another $325 billion estimated to default in the future.

Mortgage lending using highly leveraged instruments like option  
Adjustable Rate Mortgages (option ARMs) and interest-only ARMs has  
skyrocketed, with $581 billion in option ARMs in 2005 and 2006 and  
nearly $1.4 trillion in interest-only ARMs.

For a period of time, this suited both the low-income borrowers, who  
could afford to buy a house, perhaps for the first time, and billion- 
dollar lenders, who reaped enormous paper profits since they could  
book the interest payments and record the principal as assured by the  
underlying value of the house.

With the slump in home prices over the past year, however, it has  
become impossible to disguise the deterioration of the market.  
Homeowners struggling to make payments can no longer refinance their  
mortgages easily to avoid default. And these defaults are not only  
leading to foreclosures and a glut of unsalable houses, they are  
compelling many home lenders to erase profits that they have already  
booked under the lax accounting rules that allow them to record  
income even on loans where money is not coming in.

The credit crisis could have a more immediate effect on the stock  
markets next month, when bank commitments to finance nearly $300  
billion in corporate takeovers, mainly by hedge funds and private  
equity firms, will fall due. In the current liquidity squeeze, the  
banks may be compelled to revoke some of the loan agreements and pay  
huge cancellation fees, or they may have to finance the loans from  
their own capital, putting their own solvency at risk.