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Credit Crunch In U.S. Upends Global Markets
Washington Post
By Tomoeh Murakami Tse and David Cho
Washington Post Staff Writers
Friday, August 10, 2007; Page A01

NEW YORK, Aug. 9 -- The turmoil in the U.S. credit markets turned global Thursday, prompting central banks in Europe and the United States to pump more than $150 billion into the financial system to keep it operating smoothly.

U.S. stocks suffered their second-worst decline of the year as the cost of borrowing for corporations continued to rise and some investors urged policymakers to help.

Some economists predicted that the tightening credit market would be a drag on the economy, but others said the impact would be minimal. Yet signs were emerging that the nation's credit problems were spreading in unpredicted ways.

Home buyers in the Washington area, for example, where housing costs have surged, are facing higher rates for "jumbo" mortgages. New companies, which rely on credit, are finding it harder to get loans for business needs. And it may be more complicated to close major deals, such as the $45 billion acquisition of TXU by the buyout firm Kohlberg Kravis Roberts.

The injection of $130 billion into the financial markets by the European Central Bank was the largest amount ever provided in a single operation, exceeding the amount added after the Sept. 11, 2001, attacks. It came after France's biggest bank, BNP Paribas, froze three funds that had invested in the troubled U.S. mortgage market. The move sent banks in Europe scrambling for cash. The Federal Reserve followed by adding $24 billion to the U.S. banking system.

[In Japan, the central bank added $8.4 billion to money markets Friday, the Associated Press reported.]

Jonathan Muellen, a spokesman for BNP Paribas, said the bank froze the three funds after liquidity, or the ability to easily trade assets, evaporated in the U.S. mortgage market. He said about a third of the funds, which had a value of $2.2 billion as of Aug. 7, were invested in securities backed by U.S. mortgage loans made to borrowers with poor credit.

"We've no longer been able to find prices for the assets, despite the fact the quality of the underlying assets has remained high," he said. "If there's no pricing . . . we can't find the net asset value for the funds each day, which is something we must do to allow people to buy in and exit the funds."

U.S. stocks dropped significantly on the news. The prices of "safe" investments, such as U.S. Treasurys, soared. Major indexes gyrated throughout the day from speculation that other mutual funds were frozen or that more hedge funds had suffered credit-related blowups.

"Shock waves are reverberating from Europe," said Les Satlow, portfolio manager at Cabot Money Management. "It just illustrates how on edge the market it is."

[The stock market in Tokyo was down about 2 percent by mid-afternoon Friday. Other Asian markets also fell, with Hong Kong's Hang Seng index down 3 percent and South Korea's Kospi index down 4 percent.]

The Dow Jones industrial average of 30 blue-chip stocks fell 387.18 points Thursday, or 2.8 percent, to close at 13270.68. On Feb. 27, the Dow dropped 3.5 percent on concerns about the housing market and other economic issues. The Standard & Poor's 500-stock index, a broader market measure, fell 44.40 points, or 3 percent, to 1453.09. The tech-heavy Nasdaq dropped 56.49, or 2.2 percent, to 2556.49.

Stocks in every sector were battered, although companies in health care, utilities and consumer products that would be less affected by a credit crunch fared better. Particularly hard-hit were the shares of financial companies. The declines were sharp enough to trigger automatic trading curbs at the New York Stock Exchange that are designed to limit wild swings in trading.

The most pressing issue for the markets is the deteriorating condition of the credit markets, a $28 trillion segment of Wall Street that provides virtually all loans for corporate enterprises and the real estate industry. After years of lending at generous rates and terms, these markets have tightened up, as fewer lenders want to take on risky loans.

The problem is compounded because credit markets, in recent years, have evolved in complex ways. Hedge funds and other financial firms have developed tools called derivatives and credit-default swaps that slice and dice loans into pieces sold around the world. Many of these instruments are so obscure and traded so infrequently that it is difficult to know what some of them are worth.

The first signs of trouble appeared in February after lenders reported record defaults in subprime mortgages, or loans sold to people with questionable credit histories. More recently, companies with poor credit have been denied loans. Now, even credit-worthy borrowers are struggling to obtain access to debt.

Since June 20, 46 corporate loans worth $60 billion have been postponed or reduced in size, compared with last year when no deals were pulled, said Baring Asset Management, a global investment-management firm.

Companies, especially those in the mortgage industry, could suffer without easy access to money.

Countrywide Financial, the nation's largest mortgage company, said Thursday that it faced "unprecedented disruptions" in the credit markets that could severely damage the company's financial condition. Private buyouts of billion-dollar companies could be scuttled or their prices could be reduced, because such deals rely heavily on debt for their financing. Some banks are exploring ways to reduce their exposure to bad buyout deals. Home Depot said Thursday that it may drop the price of its HD Supply unit, which it agreed in June to sell to Carlyle Group of the District and a group of other private-equity firms for $10.3 billion. Home Depot also announced that it was lowering its $22.5 billion buyback offer to shareholders, citing "current market conditions." The company had planned to fund much of its buyback with loans, now an issue because of the higher cost of obtaining such debt.

Some analysts worry about companies if the credit markets are crippled for a significant amount of time.

"I don't think we sit on the precipice of a systemic breakdown, but the longer the situation goes on the more problematic it becomes for the economy," said Scott MacDonald, research director at Aladdin Capital Management.

The problems are also beginning to affect consumer spending, a key component of the economy. A report Thursday showed that July was a difficult month for retailers, a sign that a slumping housing market may have reined in spending, said Ken Perkins, president of the research firm Retail Metrics. Last month, 61 percent of retailers missed sales growth expectations for stores open at least a year. The norm is 42 percent.

"It's only going to get worse as it gets harder for consumers to get credit and make purchases," MacDonald said.

The Fed has been criticized for not cutting interest rates to calm the markets. Critics accused Chairman Ben S. Bernanke and his colleagues of not grasping the severity of the financial markets' turmoil.

"I fear that we may be significantly underestimating the magnitude of risk that remains in the markets," which could cause "significant disruption" to the economy, Joint Economic Committee Chairman Sen. Charles E. Schumer (D-N.Y.) said in a letter to the Federal Reserve this week.

Other critics said the European Central Bank's louder approach may have worsened the situation by alarming investors. "I look at it as an unprecedented response," Douglas Couden, portfolio manager for SCM Advisors, said of the European bank's move. "To the domestic equity portfolio manager like myself, it's just further proof that what started in subprime, which has spread to credit markets, is just showing up again abroad, which means it's more global in scope and it's real. It's real contagion."

President Bush said Thursday that he did not think federal regulators needed to step in to add more money to the financial system. He said the underlying economy remained strong. "I am told there is enough liquidity in the system to enable markets to correct," he said.

The Fed sought to reassure investors earlier this week. On Tuesday, central bank policymakers voted to hold the benchmark rate at 5.25 percent, saying they expect the U.S. economy to weather the financial storm.

The Fed's action implied that the policymakers did not then see signs of a crisis requiring their intervention because they generally prefer to let investors sort out the problems. So far, Fed officials have welcomed investors' newfound appreciation of the risk inherent in many securities backed by mortgages and other loans.

The U.S. central bank hopes the process continues in an orderly manner, but Fed officials also know that such a restrained adjustment may give way to panic. The bank's action Thursday shows it is closely monitoring developments and would intervene if necessary to steady markets.

Many investors are betting that the Fed would cut its benchmark interest rate by late next month, although some analysts said Fed officials do not want to pour more fuel on the fire: they see many of the recent excesses in the mortgage markets and the corporate buyout boom related to easy money. Making money cheaper to obtain might encourage more reckless lending, while at the same time bailing out investors who had made risky bets.

"We do not look for a rate cut any time soon," economists at Lehman Brothers said in a note to clients yesterday.

Some analysts say the Fed's response would depend on how much this credit squeeze affects the broader economy, which at this point is hard to predict.

"The most difficult question is how does this get worked out," said Richard A. Yamarone, director of economic research at Argus Research. "And really it's a dart toss, it's anyone's guess. If you ask a million economists you probably will get two million ways how it works out."

Staff writer Nell Henderson contributed to this report.

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