Fear that Fed's action is sign it knows of lurking danger

Suzy Jagger / Times Online | August 18, 2007

Fears that the US Federal Reserve’s hand was forced by evidence of a serious funding shortfall in a big Wall Street institution saw the Dow Jones industrial average swing within a 320-point range within the first two hours of trading yesterday.

While Wall Street's equity markets surged after it emerged that the US central bank had unexpectedly cut the short-term interest that it charges to banks by 0.5 percentage points, traders were still anxious about the continuing fallout from the sub-prime lending crisis.

Carl Weinberg, of High Frequency Economics, said: “I’m nervous. I am worried that the Fed knows something we don’t. I’m worried there’s a particular institution out there that can’t service a customer and that’s why we got this rate cut.”

Although bank stocks were among the biggest gainers — with Citigroup, the world’s biggest bank, surging 4 per cent and Lehman Brothers, the investment bank, up 5 per cent — the exposure of the big Wall Street banks to tightening credit and their ability to withstand the pressure were still at the centre of investors’ concerns.

Bear Stearns, the US investment bank, which ran two hedge funds that collectively ran up losses of $1.5 billion (£756 million), saw its shares bounce 13 per cent on rumours that it was close to securing a rescue financing package from an investor.

A report from Citigroup claimed that its rival bank JPMorgan Chase is facing a $1.4 billion loss because of loans it made to fund leveraged buy-outs — when a management team takes a company private using borrowed money — which it cannot sell on.

The report also claimed that in total, JPMorgan Chase is sitting on $40.8 billion worth of leveraged buyout debt, Goldman Sachs had $31.9 billion and Deutsche Bank with $27.3 billion.

Elsewhere, a client of Sentinel accused the cash management group, which this month froze client withdrawals, of selling client assets, without notice, at a 30 per cent discount.

The client, Penson Worldwide, indicated that it would be prepared to sue Sentinel and claimed: “We believe that to liquidate such a portfolio at such a discount to market value constitutes a reckless disregard of industry fair practice responsibilities.”

Pension Worldwide reckons it will have lost $6.5 million because of the discounted sale. The assets — government and corporate bonds — were sold to Citadel, the hedge fund.

Chris Whalen of the consultancy Institutional Risk Analytics, suggested that the rally yesterday was “a short-term flutter by a lot of scared people”.

“There is such a speculative tone on Wall Street at the moment, and I don’t know whether the participants have the maturity to take a deep breath,” he said. “The last time we had a perfect storm like this — when financial models just go out of the window — was in 1991, and not many of these guys on Wall Street now were around to see it then.”

There was evidence that the financial turmoil was having a tangible impact on employment and consumer sentiment.

NovaStar Financial, a residential mortgage lender, yesterday said it would shed a third of its staff to align it with an expected slide in lending. There were reports Bear Stearns was preparing to cut about 240 jobs at its home loan units.

The University of Michigan index of confidence among US consumers for August fell to its lowest level for a year. Americans have become cautious about spending after about 18 months of sliding house prices and rising mortgage repayments.

Sprint Nextel, America’s third- biggest mobile phone group, also gave warning that slowing economic conditions could hit subscriber growth, fuelling fears that tightening credit among banks may filter through to hit corporate earnings growth.

Oil, copper and gold prices rallied on hope that the cut in the Fed discount rate would stave off a slowing of economic growth and keep demand for raw materials buoyant. Brent crude futures for the next September delivery jumped $1.54 to $72.54 a barrel.

The Fed discount rate: an essential part of the central bank's toolkit

— The Federal Reserve’s primary discount rate, which was cut by half a percentage point yesterday to 5.75 per cent, is confusingly named: it is more expensive than the Federal funds rate, which is 5.25 per cent.

— The discount rate is simply the rate at which the Fed lends to banks and other institutions in the short term, whereas the funds rate is the rate at which they lend to each other.

— Until recently, the discount rate was set at a lower rate than the funds rate, but was subject to tests to make sure that banks who borrowed were unable to raise funds anywhere else. It was loosened to aid liquidity during the “millennium bug” and after September 11, 2001.

— In January 2003, the Fed changed the system so that the discount rate would be higher than the funds rate. The switch makes it a tool of monetary policy, albeit one whose effectiveness, according to the US Fed website, “remains to be seen”.

— Last year, the Bank of England switched to a similar system. It now has a standing facility for unlimited short-term loans, with a penalty of one percentage point above Bank Rate. Although the Bank can hold a meeting of the Monetary Policy Committee to lower the penalty, it is currently in no mood to bail anyone out.

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