Fed takes junk collateral, slashes 1-month loan rate to 4%

Fed Steps in to Quell Credit Fears

By Ambrose Evans-Pritchard
The Telegraph, London
Friday, August 17, 2007

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/08/17/cnfed1...

The US Federal Reserve has stepped in behind the scenes to avoid a disastrous meltdown across global markets, relaxing rules to let borrowers use distressed debt as collateral for raising emergency funds and quietly slashing the one-month lending rate to 4 percent.

The moves came as the Fed revealed that outstanding commercial paper in the debt markets had plummeted by $91.1 billion (£46 billion) over the past week, a clear sign that borrowers have been unable to roll over short-term debts. Instead they have had to stump up hard cash on a huge scale to meet a cascade of deadlines, forcing them to liquidate holdings across the board.

The $2,200 billion market for asset-backed commercial paper (ABCP) has emerged as the powder keg in the fast spreading crisis, which has now moved far beyond US sub-prime debt. Goldman Sachs said rates for this paper had suddenly jumped 60 basis points, if credit was available at all.

This short-term debt is used to fund long-term investments, creating a maturity mismatch that has now turned deadly. Banking sources said the Fed quietly softened its rules yesterday to let banks use ABCP loans as collateral, a move that effectively offers a government floor -- until it starts trading again.

The Fed move, and a deal by Canadian banks to unfreeze Toronto's credit markets, helped calm the panic after the worst one-day fall on global bourses since the dotcom bust. The Dow plunged 343 points in early trading, while Japan's Nikkei fell to the lowest level in almost a year as the shares of exporters plummeted on the surging yen and fears of a US recession.

South Korea's Kospi index was down 6.9 percent, with contagion spreading to almost every corner of the globe. Turkey was pummelled as the lira fell 4 percent and Istanbul bourse crashed 8 percent. The Brazilian and Mexican currencies began to buckle after holding up well at the start of the crisis, each falling 4 percent.

Funds facing a wave of redemptions stepped up the pace of firesale liquidations yesterday. The brutal surge in the yen and swiss franc added to the mayhem, forcing speculators with some $200 billion in "carry trade" contracts to cover more positions.

"The markets are discounting Armageddon," said Tim Bond, a strategist at Barclays Capital.

"The sub-prime losses have been spread through the system in such a way that nobody knows who's got what and where the losses are, so the safest thing is not to lend to anybody. The credit markets are not functioning at all. Central banks want to make sure those responsible are punished, but it's a fine line doing this without destroying parts of the system," he said.

Federal Reserve governor William Poole said America was now facing a "sort of credit crunch" but insisted that it had not yet hit the shopping malls, "No one has called up and said the sky is falling. It is premature to say this upset is changing the course of the economy in any fundamental way," he said.

Mr Poole silenced rumours of an emergency rate before the next Fed meeting in September, insisting that it would take a "calamity" to force a change in policy.

Despite the tough words, the Fed has quietly cut the rate on four-week Treasury bills to 4 percent.

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