All Eyes on the ECB

The European Central Bank's second injection of funds into the banking system may have eased some rate pressure, but not investors' fears

by Kerry Capell and Mark Scott

Does the European Central Bank know something the rest of the world doesn't? That was the question on the minds of investors and traders in Europe on Aug. 10 as the ECB, for the second day running, injected extra cash into the European banking system with the aim of restoring calm to jittery credit markets.

The move to inject $84 billion in extra funds comes on top of the record $129 billion the ECB made available to European banks the previous day—as the overnight rates that banks charge each other to lend in dollars soared to the highest levels in six years. The ECB says it will continue to add cash over the weekend if needed "to assure orderly conditions in the euro money market."

[Note: On Aug. 13, the ECB offered an additional $65.3 billion in overnight loans, after money market rates hit 4.155%. Both the lower spike in interest rates and the reduced cash injection support the central bank's claim that "market conditions are normalizing," and rates later fell as low as 3.9%, below the bank's target level of 4%. European bourses gained broadly on Aug. 13, most up around 2% or more.]

The Aug. 10 move, which was followed by additional injections of cash from the U.S. Federal Reserve and some Asian central banks, may have eased the pressure on overnight interest rates, but it did little to assuage global investors' fears that the fallout from the U.S. subprime mortgage debacle may be bigger than anticipated. Over the past two days, stock markets around the world have fallen sharply. On the heels of the bailout of IKB Deutsche Industriebank (IKBDF), a small German lender, French bank BNP Paribas (BNPQY) said it would freeze three investment funds because it could no longer accurately measure their value.

Fear of Infection

The news Aug. 9 sparked a sell-off on both sides of the Atlantic. London's FTSE 100 and the Dow Jones industrial average dropped nearly 1.9% and 2.8%, respectively. And the panic among equity investors shows no sign of abating. By mid-day Aug. 10, the FTSE 100 was down 3%. "This current correction is being driven by investors who are nervous over the extent to which the current distress in the U.S. subprime mortgage market will feed through into other credit markets and result in tighter liquidity conditions," says Edward Bonham Carter, chief executive of Jupiter Asset Management in London.

There are signs it's already happening. "For quite some time, prices of a range of credit instruments that have nothing to do with subprime have been falling quite steeply," says Simon Adamson, senior analyst at CreditSights, an independent credit research firm in London. The main exposure of subprime loans is through asset-backed securities known as collateralized debt obligations (CDOs), which are held by banks, hedge funds, and other financial institutions.

In recent months, CDOs that hold subprime mortgages have been falling in value. This, in turn, is starting to affect demand broadly for CDOs backed by other types of asset classes, not just subprime. "This is a problem for the credit markets because one of the most powerful drivers of tighter credit spreads is CDO issuance," says Barnaby Martin, European credit strategist at Merrill Lynch (MER) in London. "And if that dries up, there is little to stop spreads widening."

Banks' Buyout Burden

Moreover, the weakness in the credit markets means the prices of leveraged loans have dropped. This poses a liquidity problem for the big banks that have committed to provide financing for the slew of leveraged buyout deals agreed on this year. With prices of the loans dropping, demand has soured, leaving the banks holding the bag.

The expectation is that LBO deals will grind to a halt as there are a huge number of deals that banks need to get off their books before any new ones can be placed. Analysts estimate that there is $96 billion worth of leveraged loan deals in Europe, and a further $230 billion in the U.S., that must find investors. With that kind of backlog, market watchers expect the value of these secondary loans to fall a lot further.

Credit analysts also fear that there may be future shocks in store. There are fears that hedge funds—as big buyers of both leveraged loans and high-yield debt—may also be facing sizeable losses. "If they are subject to redemptions from investors and/or margin calls from brokers, then we could see some forced selling," Merrill's Martin says. Adds Paul Niven, head of asset allocation at Foreign & Colonial Investments (FRCL) in London, "There will be ongoing financial problems and many hedge funds are in the process of going to the wall."

Investor Worry: Worst Yet to Come?

The real problem is the lack of disclosure. Banks have been trying to reassure the market that their exposure to asset-backed securities is manageable. "But the market, at the moment, just doesn't buy it," says CreditSights' Adamson. Investor skepticism is understandable. With major banks such as BNP Paribas claiming the volatility in the credit markets has made it impossible to value their investments, it's little wonder investors worry whether the worst has yet to come.

For now, there is little more central bankers can do to reassure the markets. "All they can do is manage the money markets," says Marc Ostwald, fixed-income strategist at Insinger de Beaufort in London. "What they don't want to do is wander into an area of moral hazard and bail out the system by effectively sanctioning what, in some cases, has been poor lending standards and poorly judged investment."

Capell is a senior writer in BusinessWeek's London bureau. Scott is a reporter in BusinessWeek's London bureau.