Credit Crisis Update: Markets Plunge on Costly Credit, Paulson to Buy Bank Shares, IMF Warns of Global Recession

By Jennifer Yousfi
Managing Editor
Money Morning

Global markets had deep sell-offs yesterday (Tuesday) as short-term credit markets remained tight, with the three-month lending rate for banks hitting a yearly high.

The London Interbank Offered Rate (LIBOR) for three-month dollar-denominated loans hit 4.75%, its highest rate so far this year. The LIBOR rate for overnight lending dropped, to 5.09%, but still remains well above the Federal Funds target rate of 1.5%.

The message from [yesterday's] Libor fixings is that [Wednesday's] unprecedented measures have yet to have much impact on term rates other than overnight,” Barclays Capital PLC (ADR: BCS) economists Julian Callow and Nick Matthews wrote in a research note,  reported.

The global financial markets showed other signs of strain, including:

  • Plunging bourses worldwide.
  • U.S. Treasury Secretary Henry M. Paulson’s indication that the federal government could move forward with capital infusions for financial firms.
  • And urging from the International Monetary Fund (IMF) and World Bank for continued coordinated global efforts to fight the crisis.
  • And additional rate cuts, this time in Asia.

Interest Rate Reaction

Wednesday’s dramatic coordinated rate cut was followed yesterday by rate cuts from the central banks of Hong Kong, South Korea, and Taiwan. But interest rates remained little changed, as banks continue to be extremely gun-shy about lending to one another.

To see little or no reaction in the fixings is very disappointing and reinforces the fact that LIBOR is broken and the transmission mechanism from central banks isn't working,” Barry Moran, a currency trader in Dublin at Bank of Ireland (ADR: IRE), told Bloomberg News. “Things are still very stressed and we don't know what's going to fix it.”

Wednesday’s coordinated rate cut effort – the first between the U.S. Federal Reserve, European Central Bank (ECB) and other major central banks since Sept. 2001 – didn’t provide the desired relief, as short-term credit remained both costly, and hard to come by.

All three major U.S. indices were deep in the red at the close in New York yesterday.

The Dow Jones Industrial Average plunged 678.91 points, or 7.33%, to close at 8,579.19, marking the first time the blue-chip index has fallen below 9,000 since late August 2003.

The tech-laden Nasdaq Composite Index plummeted 95.21 points, or 5.47%, to close at 1,645.12. And the broader Standard & Poor’s 500 Index plunged 75.02 points, or 7.62%, to finish the day at 909.92.

All three indices are well into bear-market territory during this year alone, with the Dow down 35%, the Nasdaq down almost 38% and the S&P 500 down 38%.

Interestingly, yesterday was the one-year anniversary of the Dow’s record close at 14,164.53. The 30-stock blue-chip index has plunged 39% since that Oct. 9, 2007 record close.

Only Hong Kong’s Hang Seng Index was able to buck the global losing trend, gaining 511.51 points, or 3.3%, earlier yesterday, to close at 15,943.20. Japan’s Nikkei 225 Index dropped 45.83 points to close at 9,157.49.

Meanwhile, Europe’s blue-chip FTSEurofirst 300 Index slumped 2.1%.

“Policymakers must keep fighting,” Marco Annunziata, chief economist at UniCredit MIB, told MarketWatch. “They must keep hitting the markets with decisive measures in the coming days; the market will eventually surrender. What more can they do?”

Paulson’s New Plan?

U.S. Treasury Secretary Paulson thinks there is at least one more thing he can do. As part of the $700 billion banking bailout legislation signed into law late last week, Paulson has the authority to buy stakes in battered financial institutions in order to boost capital positions.

The Treasury is no longer looking for one silver bullet,” Steve Bartlett, president of the Financial Services Roundtable, which represents 100 of the biggest firms in the industry, told Bloomberg News. “They have to proceed on all fronts.”

Similar to the U.K. bank recapitalization plan announced Wednesday, the Treasury can purchase preferred or common shares in liquidity-starved banks that result in an ownership position for the U.S. government. However, the Treasury Department would not seek seats on the board of directors of banks that participate in the capital infusion program.

Under the new law, the Treasury Department’s authority extends beyond just mortgage-related assets to “any other troubled assets that the Treasury and the Federal Reserve deem necessary to promote financial market stability,” Paulson told The Wall Street Journal at a press conference yesterday.

Sources close to Paulson say the Treasury could begin buying bank shares by the end of this month.

United Front in Face of Crisis

The IMF and World Bank each called separately on Group of Seven (G7) financial leaders and the European Union to work together to continue to combat the current credit crisis.

Financial ministers from Canada, France, Germany, Italy, Japan, the United Kingdom and the United States will meet today (Friday) to discuss possible coordinated moves.

"I hope the G-7 will point toward coordinated action to show that authorities are getting ahead of the curve," World Bank President Robert Zoellick said in advance of today’s meeting.

The IMF also urged cooperation between global financial leaders in the face of the worst financial crisis since the 1930s, The Journal reported.

“The situation is very serious, but at the same time that we can solve problems if we act quickly, forcefully and cooperatively,” IMF Managing Director Dominique Strauss-Kahn said in a separate briefing.

Strauss-Kahn said the world is “on the cusp of a global recession,” but that he expects the beginning of a recovery by late 2009.

The IMF cut its global forecast for economic growth for 2008 to 3.9% from a July forecast of 4.1%. It also revised its 2009 projection downward to 3.0% from an earlier 3.9%.

The IMF activated its emergency finance response plan for the first time since the 1997 Asian Financial Crisis. Countries in need will be able to access emergency funds through the response plan, which will speed up the approval of loans.

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