Subprime: The Ugly American Hits Europe

French bank BNP suspends subprime-linked funds. Europe's central bank responds; stocks tumble

by Will Andrews

Financial markets' tentative optimism on Aug. 8—when investors appeared to be less worried about the effects of credit-market contagion from the U.S. subprime crisis on the global economy—vanished quickly one day later. The main players in the latest drama were a money-center French bank, the European Central Bank, and the Federal Reserve.

Cracks in the market's calm façade began to appear after a unit of French banking group BNP Paribas (BNPP.PA) said it temporarily suspended three funds with U.S. subprime exposure as a result of a current lack of liquidity in the market, according to news reports. Equity indexes in Europe—and stock futures in the U.S.—fell on the news.

"The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly regardless of their quality or credit rating," said BNP Paribas in a press release. The bank said it would suspend three funds, Parvest Dynamic ABS, BNP Paribas ABS Euribor and BNP Paribas ABS Eonia, with a total value of around €1.5 billion ($2.065 billion).

Calming the Waters

Another, bigger, shoe dropped later Thursday. The European Central Bank, in a move to calm market nerves and enhance liquidity in the European money markets, said it planned "a liquidity-providing tender of one-day securities" totaling €94.8 billion ($130.5 billion)—basically, an injection of available funds into euro zone money markets to soothe frayed market nerves. In the wake of the BNP news and other gnawing concerns over credit tightening, money-market rates had shot up Thursday morning in Europe—from the ECB's target zone between 4.0% and 4.1% to nearly 4.6%.

The ECB said it would allot all bids received at a fixed rate of 4%—cheap money. The bid was meant to calm markets and bring overnight rates down amid uncertainty over the fallout from the U.S. subprime crisis and implications for European banks.

But central-bank moves meant to reassure investors often fuel worries that financial crises are deeper than investors originally feared. And Europe's central bankers weren't the only ones on alert. The Federal Reserve injected $12 billion in reserves into the U.S. financial system Thursday. Action Economics noted market rumors that U.S. and ECB officials had been in contact overnight.

European Subprime Proxy

The ECB's thinking about the crisis clearly has been evolving fast. According to Action Economics, the ECB actually drained funds in this week's regular tender operation and "clearly deemed liquidity to be appropriate." But the unusual fact that the ECB then pledged to allot 100% of all bids, rather than allotting a fixed amount, highlights that the ECB felt compelled to counter the mounting uncertainties about the credit markets and policymakers' commitment to stability. In any event, the amount allotted was unprecedented, says Action Economics, though in relative terms it was lower than the amount the bank pumped into the market after the September 11 terrorist attacks in the U.S.

Closely watched credit-market gauges were also signaling trouble Thursday. The iTraxx Crossover index, which measures credit spreads on 50 European corporate high-yield debt issues, widened sharply after the Paribas fund freeze and a Wall Street Journal report that Goldman Sachs' (GS) Global Alpha fund lost 16%. Traders have been using the index as a proxy for subprime contagion in Europe, according to Action Economics. The iTraxx index gained 25 basis points, to around 350, on Thursday.

Standard & Poor's European strategist Robert Quinn says the ECB's move was "unexpected" and suggests the central bank expects more exposure to subprime losses among European banks than the market previously feared. Quinn notes that overnight lending rates in Britain and Europe soared 50 and 70 basis points, respectively, after the Paribas news. "If anything, this ECB move reduces the likelihood of a final rate hike in September to 4.25%, and may push it back to the end of the year," he wrote in an Aug. 9 note.