Sub-prime lending slump sends markets into freefall

Stock markets plunged around the globe as central bankers fought for a second day to head off a complete shutdown in the credit markets that could cripple economic activity.

The US Federal Reserve provided emergency funding for the banking system and said it stood ready to do more, but its chairman, Ben Bernanke, faced criticism that he has acted too slowly to stem losses on Wall Street.

The Fed injected $38bn into the financial system yesterday, a day after an even bigger move by the European Central Bank. The ECB also acted again, adding a further €61bn in extra liquidity to the €95bn it released on Thursday.

"The Federal Reserve is providing liquidity to facilitate the orderly functioning of financial markets," it said, in an unscheduled statement that underlined the severity of the stress felt by the banking system. "In current circumstances, depository institutions may experience unusual funding needs because of dislocations in money and credit markets."

Lenders have been spooked by the meltdown of the US sub-prime mortgage market, which has affected trillions of dollars of other financial assets ultimately backed by mortgage payments from low-income Americans.

"This has culminated in banks ramping up the overnight rates which are charged to each other for loans due to mistrust and uncertainty over creditworthiness of even the biggest financial institutions," explained Paul Niven, head of asset allocation at F&C Asset Management. Central banks are trying to push overnight rates back close to the official interest rate, which they typically set at monthly meetings. In the US, the federal funds rate opened at 6 per cent, the highest in six years, but it fell back to its official target of 5.25 per cent when the New York Fed bought $19bn of mortgage-backed securities and then followed up with $16bn of funds in a second operation.

British overnight interest rates soared to 6.5 per cent, 75 basis points above the Bank of England's main rate, but the UK's central bank did not follow the Fed and the ECB in injecting additional liquidity. The Bank of England usually acts if rates move to a 100 basis point premium.

"Current events have rings of 1998, where systemic risks related to hedge fund losses threatened to bring global financial markets to their knees," said Mr Niven. "Now, as a decade ago, there is great uncertainty as to how far risks are spread within the financial system and exactly where the losses reside. The market is trading on fear and financials are bearing the brunt."

The panic wrought a second day of losses in the equity markets. The FTSE 100 closed down 191 points at 6090. From the high of 6732 that it touched in June the benchmark index has shed 9.3 per cent of its value, pushing it close to "correction" territory. A market correction is usually defined as a 10 per cent drop. Many European bourses moved beyond that point yesterday.

The Fed's actions appeared to calm some nerves, and the Dow Jones Industrial Average swung from an early 213-point loss to trade broadly flat at lunchtime in New York. It closed down 31.14 points at 13,239.54.

Investigators from the Securities and Exchange Commission, Wall Street's regulator, are touring major investment banks in search of hidden losses. The banks are withdrawing loans to hedge funds and demanding more collateral because of the collapse in value of mortgage-backed debt products, but the SEC is concerned that the banks themselves may not be properly accounting for similar products on their own books.

Nevertheless, many hedge funds on both sides of the Atlantic continued to flee the financial markets yesterday, under pressure from their lenders and investors, and amid confusion over the value of many of their most important assets. Some funds are down between 10 and 30 per cent since the start of August, particularly those which use computer programs to trade in the financial markets.

The financial turmoil is the biggest test to date for Ben Bernanke, who took over as chairman of the Federal Reserve from Alan Greenspan last year. In recent testimony to Congress, he insisted the fallout from rising defaults in the sub-prime market was "likely to be contained", and just this week the Fed insisted that the main risk to the economy was inflation, and that it had a bias towards interest rate rises.

The financial markets now expect a Fed U-turn and a rate cut next month, and David Owen, an analyst at Dresdner Kleinwort, said that if the situation worsens the ECB or the Bank of England might even institute an emergency rate reduction before that. "Would they cut rates if rate cuts were felt necessary? The answer has to be yes," he said.

How the events unfolded

Late 2006 - The rot starts as rising US interest rates mean some mortgage borrowers begin to experience difficulty in maintaining payments. Some lenders report significant problems with their US mortgage portfolios but the market reaction is muted - for now, it is a problem for a handful of niche lenders and borrowers.

February 2007 - The Dow drops 416 points, its largest one-day points fall in more than five years, after a sell-off in China fuels fears about US and global growth.

March 2007- US Congress begins a public inquiry into the practices of lending companies.

April 2007 - New Century, the second biggest sub-prime mortgage lender, files for bankruptcy.

June 2007 - By the end of the month the crisis spreads to Wall Street - Bear Stearns confirms that it will shut two hedge funds that suffered heavy losses after investing heavily in sub-prime mortgages. Sellers of sub- prime mortgage-backed bonds begin taking huge discounts on their book values to get out .

August 2007 - French bank BNP Paribas freezes the assets of three funds linked to US mortgage securities.

The European Central Bank pumps €94.8bn into the money markets to improve liquidity while the US Federal Reserve adds $24bn, but by now the markets are in freefall.