Credit crunch 2.0

  • Robert Peston
  • 7 Mar 08, 01:37 PM

The vicious credit cycle currently ruling our global financial economy has entered a new and worrying phase.

What began in the autumn of 2006 with a rise in defaults on US sub-prime loans is now manifesting itself in growing delinquency rates on US mortgages in general and the growing unease of lenders about ostensibly good quality mortgages.

That was what caused the collapse of the London-based hedge fund, Peloton. The lenders to Peloton demanded their money back after its holdings of mortgage-backed securities start to fall in value.

And an investment vehicle of the substantial Carlyle Group is in schtuck because its lenders are demanding increased collateral against holdings of more than £10bn in US government agency AAA-rated residential mortgage-backed securities.

Only last week Carlyle Capital Corporation calculated it had sufficient liquidity. Now it's warning that it may run out of liquid assets and that its capital may be impaired.

Why does any of this matter? Well it shows that contagion from sub-prime to other assets is becoming serious.

That will further deplete the capital of the financial institutions - the banks and insurers - upon which we all depend for credit.

It also suggests we are still early in the process of returning to the mean from all those years of under-priced debt and over-priced assets.

Returning to the mean, or a sensible level of pricing, was never going to be painless. But the pain - in the form of the impact on the real economy - could be pretty horrible if we overshoot in the other direction and debt becomes punitively scarce and dear.

UPDATE 04:45PM: The US Federal Reserve has taken emergency action today to (in its words) “address liquidity pressures in the funding markets.”

It has identified lenders’ growing distaste for all classes of mortgage-backed securities as a serious source of further strains in credit markets and has announced increases in the size of its credit auctions to $100bn – and it is also making another $100bn available through term repurchase operations.

The Fed has signalled its determination to do all it can to restore confidence in the financial system by saying it stands ready to provide even greater funds if necessary.

The 28-day repurchase agreements will allow primary dealers (banks and broker dealers that trade directly with the Fed) to borrow against all and any class of securities, including the agency-backed mortgages being shunned by many private-sector institutions.

The effect of the Fed’s measures is to supply banks and financial institutions with the liquid funds that they can’t currently obtain on the commercial markets.

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