Five of the world's most important central banks had joined together to promise they would rescue the stricken credit markets, but investors can't decide between euphoria and more despair.
The credit markets didn't suddenly thaw, banks didn't instantly start lending to each other again, the crucial inter-bank interest rate that measures these things stayed stubbornly close to its highs. But yesterday's gloomy predictions that the interventions are failing are as premature as Wednesday's elation.
What exactly do we mean when we ask, will it work? There are two main measures. First and foremost, the central banks are trying to avoid any more banking blow-ups such as the one at Northern Rock in September. That has been a particularly acute concern as the end of the year approaches, an important moment in the accounting calendar when banks may need to top up collateral for loans and recapitalise other parts of their business.
Secondly, and more broadly, the central banks hope to thaw the frozen credit markets and bring down market interest rates. Banks and the money market funds that grease the financial system have become more reluctant to lend to each other, because they have their own requirements for the money and because they fear their rivals may not be able to pay them back. That has a cascading effect through the credit markets: businesses have found it harder and more expensive to borrow cash to fund their operations, mortgages are harder to come by, the wider economy is threatened.
On Wednesday, central bankers unveiled a raft of creative ways to encourage institutions to come to them for funds instead of relying on each other, in the hope that this will, eventually, reduce the fear that has paralysed the markets. Where normally the central banks would hand out loans at a predetermined, punitive, interest rate via what is called the "discount window", they will next week begin offering more than $100bn (49bn) of loans by way of an auction. As well as reducing the stigma, it should also reduce the interest rate on borrowings from the central banks, and that might be enough to tempt in participants looking for a bargain.
Andy Hornby, the chief executive of HBOS, said he did not understand the market's negative reaction yesterday. "I only see upside in it. It is good to see concerted action. These are worldwide markets. All wholesale markets are by implication global."
He predicted that banks will participate in the auctions, the first of which are being held by the ECB and the Fed on Monday, with the Bank of England following on Tuesday. "There will be general demand for more," Mr Hornby said.
John Ewan, the director of the British Bankers' Association, said that other members were also cautiously optimistic about the new plan.
"Banks don't want to use the discount window because, whatever the reason they use it, they can be perceived as having trouble funding themselves. And as we know, it is a short step from the perception of Bank X being in trouble to Bank X really getting into trouble," Mr Ewan said, making a nod to the run on Northern Rock.
"The sums involved in the central banks' intervention are relatively small in comparison to the size of the losses suffered on sub-prime mortgages, which are estimated in the hundreds of billions of dollars. But central banks have left themselves room to intervene again in the coming weeks if it is necessary. More of the same would be welcome, but the members I have spoken to are happier than they were two days ago."
Jonathan Wilmot, the fixed-income researcher at Credit Suisse, said he suspected the Fed was keen to encourage arbitraging. In other words, that banks would participate in the auction in the hope of raising funds at a low level, then lending them straight back out to other institutions at what is currently a high inter-bank lending rate, known as Libor. That extra supply would then drive Libor down closer to the target interest rates that the Fed, the Bank of England and others use to manipulate their economies.
But the Libor interest rate did not crash yesterday, disappointing many who had expected that the central banks' announcement on its own would be enough to ungum the credit markets. In the eurozone, the cost to borrow for three months remained completely unchanged at 4.95 per cent, 95 basis points more than the ECB's benchmark interest rate of 4 per cent, compared with 57 basis points a month ago. The difference averaged 25 basis points in the first half of the year, before losses on securities on US sub-prime mortgages contaminated credit markets. Sterling Libor dropped a modest 12 basis points.
In a note to clients, Mr Wilmot wrote that reducing the rates at which banks lend between each other "will depend on the willingness to lend and not hoard new deposits received [from central banks]. The jury will remain out on this measure until we actually see how banks behave with this money."
The BBA's Mr Ewan concurred. "There is not likely to be a moment where we can say 'gosh, chaps, it's almost like June again'. Libor is more likely to come drifting down rather than drop suddenly."
Mr Wilmot and his colleagues at Credit Suisse yesterday also highlighted other ways that the central banks' new plan will alleviate pressure on financial institutions. By widening the types of assets that can be used as collateral to include some types of mortgage-backed credit derivatives (called collateralised debt obligations, or CDOs), the Federal Reserve will be reducing the unwanted supply of these riskier types of assets in the market.
Best of all, the face value of many CDOs is higher than they would actually fetch in the market, so handing them to the Fed as collateral for a loan is much better for a bank than selling them. At the very least, banks are delaying crystallising their losses, and may avoid a big loss all together if prices rebound in the new year.
John Lonski, an economist at the credit rating agency Moody's, is another with a "jury-is-out" viewpoint, but he suggests that credit markets are gripped by an irrationality that might not properly be shaken until the outlook for the US economy is clearer. Junk bonds are pricing in a significantly sharper rise in corporate debt defaults than seems likely, he says, and the value of mortgage-backed derivatives suggests a higher rate of defaults by borrowers than seems possible. And yet, markets continue to demand big interest rate cuts by the Fed to stimulate the whole economy.
In other words, the markets simply are not listening to central banks.
"We continue to see a high level of risk aversion in the banking sector, but it does not appear to be reflected in the observable fundamentals.
"It's a battle. The Fed clearly does not think the outlook is as dire as the financial markets believe," Mr Lonski said.
"Of course, we are looking at the deepest cutbacks in financial services sector employment since the early Nineties, so perhaps it is understandable that Wall Street has a gloomy view of the prospects for 2008."
Off-balance-sheet rescue plan
The casualties of the credit crisis are littered all around among them, rescue plans meant to ease the crisis.
Less than two months ago, Hank Paulson, the US Treasury Secretary, was trumpeting an idea meant to prevent tens of billions of dollars of losses on the secretive off-balance-sheet vehicles created by investment banks such as Citigroup, Barclays and others.
Citigroup said it was leading a consortium of financial institutions to create an $80bn-$100bn fund that would buy up mortgage-backed debts that few other Wall Street investors now want to buy. The plan was thrashed out at meetings organised by Mr Paulson, but even his intervention could not rouse significant support.
All week, Citigroup and its two partners, Bank of America and JP Morgan Chase, have been trying to drum up money for the fund, but it is clear that it will have to be scaled back. Executives at two banks, Sumitomo Mitsui of Japan and the US-based Wachovia, played down the importance of the fund, while many others behind the scenes have turned down a chance to participate.
The aim of the fund, called the Master Liquidity Enhancement Conduit (M-LEC), is to prop up dozens of off-balance-sheet vehicles known variously as structured investment vehicles, SIVs. SIVs raise money at low interest rates in the short-term debt markets to buy longer-term investments, mainly mortgage-related securities, which pay a higher interest rate. The value of the longer-term assets has collapsed, however, and SIVs are finding it hard to find outside investors to refinance them. The M-LEC is meant to step in as a buyer of last resort for assets that might otherwise have to be sold at fire-sale prices.
Analysts say that banks are finding other, albeit more painful, ways to resolve their leaking SIVs. HSBC has bailed out its vehicles by taking the assets on to their balance sheet.
Stephen FoleyReuse content