Sunday, March 16, 2008

Credit crisis reveals America's secret financial market

Sun Mar 16, 12:18 AM

WASHINGTON (AFP) - The financial hurricane tearing through Wall Street has sparked vast losses at major banks, but it has also exposed a formerly secretive corner of America's financial markets.

Millions of Americans track the Dow Jones Industrial Average and their stock portfolios on a daily basis, but the trillion-dollar trade in mortgage-backed securities, corporate and municipal bonds and other complex securities is mostly hidden and closed to amateur investors.

Mounting losses on mortgage securities have affected other complex debt instruments and deepened a credit crunch that has reverberated around the world.

Banks in New York, London and Zurich are trying to offload their exposure to such securities, but the opaque nature of a market where trades occur between banks rather than on an open exchange appears to have scared off buyers in the current uncertain climate.

"The subprime problem spread to the banks and from the banks it has now spread to the credit markets and it has become a vicious cycle," said John Praveen, the chief investment strategist for Prudential International Investment Advisers, LLC.

The credit squeeze was triggered by a sharp rise in subprime mortgage defaults, or home loans granted to Americans with poor credit, because banks had bundled and resold subprime loans to other parties.

The angst worsened Friday as Bear Stearns, a large US investment bank, said it had obtained an emergency loan from the Federal Reserve Bank of New York through rival bank JPMorgan Chase.

Bear Stearns chief executive Alan Schwartz said the bank's liquidity had "signficantly deteriorated" in just 24 hours as it battled to stem losses linked to mortgage-backed securities.

Cracks first began appearing in the credit markets in mid-2007 when financial firms revealed they were slashing the value of their mortgage portfolios due to the US housing slump.

The resulting losses forced some of America's biggest banks to restrict fresh lending and demand collateral from borrowers as they sought to preserve cash.

Debt became toxic and cash became king as the banks turned off lending spigots that had fueled a boom in corporate mergers and acquisitions.

The liquidity squeeze has deepened in recent months as private-equity firms and hedge funds, which had borrowed heavily, sought to sell investments, but struggled to find purchasers.

An affiliate of the Carlyle Group, a giant US private equity firm, defaulted on almost 17 billion dollars of debt on Thursday and several small hedge funds have collapsed in recent weeks.

US President George W. Bush and the Federal Reserve have backed various measures, including sustained interest rate cuts, to ease the credit crunch, but it shows no sign of abating.

Treasury Secretary Henry Paulson, Fed chairman Ben Bernanke and Securities and Exchange Commission (SEC) chairman Christopher Cox urged banks, credit rating agencies and mortgage firms, to overhaul their practices Thursday.

The financial chiefs endorsed a range of recommendations aimed at boosting business transparency and restoring confidence in America's battered financial markets.

The intensifying credit turmoil is threatening some public works projects and is making it harder for firms to get business loans and for students to obtain loans for university courses.

The director of the SEC's division of trading and markets, Erik Sirri, told Congress last week that the contagion had spread to municipal bond auctions.

"There is no question that the recent dislocations in the municipal bond markets have created unanticipated hardships for municipal issuers and in some cases dramatically increased their borrowing costs," Sirri said.

If US cities and states cannot sell municipal bonds to investors it could threaten plans to build new roads, schools, airports and other public works projects.

The state of Michigan has temporarily suspended a student loan program called MI-LOAN citing "the current and unprecedented capital markets dislocation."

Veteran money managers say the escalating credit crisis is one of the worst they have witnessed in recent decades and could push the economy into a recession.

Praveen said economic growth will likely rebound in the third quarter due to a 168-billion-dollar government economic stimulus package, but he said consumers will need to keep spending to keep the economy on its legs.

As the British economist John Maynard Keynes once said: "The market can stay irrational longer than you can stay solvent."

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