Global Policy Forum

By Carter Dougherty

The European Central Bank pumped a record €348 billion into the financial system Tuesday, dramatically easing the tight conditions in credit markets that have been grappling with a global lending crunch linked to the U.S. housing crisis, on top of traditional year-end demands for ready cash.

Interest rates for two-week loans - the maturity at which the ECB lent the colossal sum, equal to $501 billion, to banks - plunged a half percentage point, or 50 basis points, to 4.45 percent, reflecting the vastly increased supply of money being provided by the lender of last resort. The duration of the loans should ensure that liquidity is readily available through the end of the year, credit analysts said. The Bank of England also did its part, auctioning off £10 billion, or $20.12 billion, in three-month loans. But Mervyn King, the governor of the British bank, conceded that central banks were reaching the limits of their ability to ease the five-month-old credit crisis.

Despite a range of unusual cash injections, central banks in the United States, Europe and Britain have been unable to bring down spreads - the difference between their benchmark policy rates and rates that banks charge one another for short-term lending. The three-month lending rate fell a tenth of a percentage point to about 4.8 percent Tuesday, a sizable one-day drop though the rate remained far higher than normal. That reflects a continuing reluctance of banks to trust each others' creditworthiness in the wake of extensive write-downs linked with bad investments in the deteriorating U.S. mortgage market - a problem central banks can influence only obliquely.

"The difficulty we face is that even the operations we put in place cannot be guaranteed, and are indeed unlikely to bring about a significant reduction in spreads - except insofar as the operations can improve the confidence of the banking sector," King told a committee of Parliament. "It's hard to say whether it will turn out to be an important step." King was referring to liquidity injections in general, as well as a coordinated effort led by the U.S. Federal Reserve last week to pump $64 billion into the system via central banks in North America and Europe. The results of that action will be announced Wednesday.

Even judging by the unsettled atmosphere that has reigned since August, the ECB delivered a dramatic shock to the system Tuesday. Late Monday, the ECB announced that it would guarantee unlimited two-week loans to banks at a fixed rate of 4.21 percent, rather taking its standard approach of fixing the amount it lent and allowing overall demand to determine the cost of borrowing. The normal tactic would have resulted in an infusion of roughly €180 billion, the ECB said. Although the ECB took the same approach when the credit crisis erupted Aug. 9, the scale of the intervention at that time was much smaller - about €95 billion in overnight funds. By acting so forcefully, analysts said, the ECB was seeking to guard against a fresh outbreak of credit market chaos at year's end, a time normally ripe for volatility.

Vexed primarily by ripple effects from the United States, global credit markets also are coping with the surge in demand for cash that is common as banks clean up balance sheets and meet obligations before Dec. 31. The money lent Tuesday will come due Jan. 4. "Atop the usual uncertainty, the ECB was worried about what the year-end market might look like," said Erik Nielsen, chief Europe economist at Goldman Sachs in London. "So they put a lid on it like only central banks can do." Yet the uncertainty about who will have to absorb the losses from the U.S. mortgage debacle seems certain to keep short-term lending rates stubbornly elevated into the new year, economists and credit strategists said.

Central banks have treated the crisis as a shortage of liquidity - the ability to raise short-term cash - but the deeper problem relates to the solvency of banks which might have speculated in securities linked to mortgages given to U.S. borrowers with spotty credit records, analysts said. Central banks have so far bet that by providing liquidity, they buy time for other issues, like the creditworthiness of banks and their exposure to subprime lending in the United States, to work themselves out. "We might well be facing a solvency issue, but we are in a situation where liquidity and solvency are very intertwined," said Marco Annunziata, chief economist at UniCredit in London. "The lack of liquidity exaggerates the solvency problems that are there."

Worries about the solvency of borrowers are leading banks to push up short-term lending rates as a hedge. This dynamic has helped keep the three-month lending rate much further above central bank's policy rates than normally is the case. King made clear Tuesday that the problem would linger. "The problems in the financial sector remain with us," he said. "A painful adjustment faces the global banking sector over the next few months as losses are revealed and new capital is raised to repair bank balance sheets."

Some banks, like Citigroup and UBS, have made large write-offs while simultaneously raising new capital, thus ensuring that their overall financial position remains strong. Yet the Organization for Economic Cooperation and Development has estimated that losses could reach $300 billion; write-offs so far total only about a fifth of that.

The longer banks are reluctant to lend to one another, the greater the risk that the credit crunch will spread beyond the financial sector to the rest of the economy. The three-month lending rate in particular affects credit costs for nonfinancial borrowers. "We don't yet know what the approach will be from the banking community," said Audrey Childe-Freeman, chief Europe economist at CIBC World Markets in London. "The real risk is that we get new losses being revealed past the first quarter of next year." S&P cuts ratings on debt

Standard & Poor's said Tuesday that it lowered ratings on $6.7 billion of collateralized debt obligations whose holdings include home-loan bonds, adding to unprecedented downgrades in a category causing the largest losses for credit investors, Bloomberg News reported from New York. S&P lowered 156 classes of 36 CDOs, the ratings company said. There is a "significant likelihood of further downgrades" on 57 of the bonds, along with 63 bonds from other CDOs that had $3.6 billion in initial balances, S&P said. S&P has so far downgraded or placed under review $57 billion of CDOs "as a result of stress in the residential mortgage market and credit deterioration" among U.S. home-loan bonds, the statement said. CDOs repackage assets such as mortgage bonds or buyout loans into new securities with varying risks.