Panic eases, credit woes persist

Fed's move to cut discount rate fends off liquidity squeeze, but underlying credit problems aren't going away.

By Grace Wong, CNNMoney.com staff writer

LONDON (CNNMoney.com) -- The Federal Reserve's move to encourage bank lending last week has helped ease some of the panic in financial markets, but the underlying problems that led to the seizing up of credit are still there - and won't disappear overnight.

The credit crisis escalated last week, forcing the Fed on Friday to cut its little used discount rate - the rate it charges member banks for temporary loans - a rare move for the central bank.

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The Fed's move immediately helped restore some measure of calm to global markets. From New York to London to Tokyo, stocks soared after the Fed intervened, although Wall Street struggled to keep up the rally early Monday.

The cut in the discount rate should help money markets stabilize, analysts said. But the broader credit market is still working through the problems at the root of the crisis, which means certain long-term borrowers will face difficulty getting financing for some time.

"In terms of short-term liquidity, the banks have got that under control," said Orlando Green, a fixed-income strategist at investment bank Calyon in London.

The Fed took a dramatic step to combat the squeeze on liquidity last week. When banks became unwilling to lend funds, even to creditworthy investors, the Fed cut its discount rate by half a percentage point to 5.75 percent and extended its loan period to 30 days, from one day previously.

The Fed's move has helped temporarily with liquidity, but it has no real impact on the problems behind the credit turmoil, said Dan Castro, managing director at GSC Group in New York.

"In reality, credit issues from mortgages that shouldn't have been written to borrowers aren't going to go away. That paper is still going to be around," he said.

Risky subprime mortgages and the complex securities they have been packaged into have been at the heart of the current crisis sweeping Wall Street. As default rates on home loans have risen in the United States, the value of these securities took a big hit, and the shock waves quickly spread through the global credit markets, triggering a massive repricing of risk around the world.

The dislocation in the markets occurring now that investors are demanding higher returns for putting their money at risk will continue, analysts say - meaning money will remain hard to come by for certain borrowers.

With problems in the housing market running deep, financing will remain difficult for mortgage lenders. Last week, the largest U.S. mortgage lender, Countrywide Financial (Charts, Fortune 500), had to tap an $11.5 billion line of bank credit since it couldn't raise funds as it normally does in the markets.

Mortgage lender Thornburg Mortgage (Charts) said Monday it sold about $20.5 billion of assets to meet short-term financing needs. Chief operating officer Larry Goldstone said the mortgage financing market is the worse the company has seen in more than a decade. The company specializes in so-called jumbo adjustable-rate loans.

The credit quality of Thornburg's portfolio, along with its liquidity and limits on leverage, have helped the company weather difficult financing markets over the last 14 years, he said in a statement. But the current mortgage finance market has been "even more disruptive" than some of the toughest periods in the past.

KKR Financial (Charts), an affiliate of buyout firm KKR that earlier this month sold about $5.1 billion of residential mortgage loans due to tough market conditions, moved to raise another $500 million Monday by selling stock and other related securities.

As mortgage lenders get squeezed, home buyers are expected to keep feeling the pain. Those with weak credit will be cut off completely while other borrowers will face higher costs, according to Tim Drayson, international economist at ABN Amro in London.

Highly indebted companies are also going to have trouble raising funds for at least several more quarters, Drayson said. "On the corporate side, aggressive leveraged buyouts and deals - they'll stop. Those companies borrowing heavily will be less able to invest."

The Fed's decision to cut the discount rate was designed to get banks lending again and reassure the market - and so far that appears to be working. But for borrowers, the real move to watch is the one the Fed takes on its more closely watched fed funds rate, a key short-term rate that influences rates on a variety of consumer loans.

Some analysts said it looks more likely now that the Fed will cut this rate to keep the credit crunch from becoming a drag on economic growth when it next meets on Sept. 18, or even earlier if there's further turmoil in the credit markets. The fed funds rate now stands at 5.25 percent.

In a statement last week, the Fed said it's "prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets."

The Fed will have to strike a fine balance with its next move, said Green from Calyon. A rate cut will help stem the current hysteria, but the central bank doesn't want to bail out or underwrite those responsible for the credit mess in the first place.

"They have to shore up confidence in the market but can't go too far with rate cuts to encourage irresponsible lending practices again," he said. "They don't want to recreate that scenario." Top of page

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.