U.S. credit squeeze frays world financial markets

NEW YORK Fri Aug 3, 2007 6:42pm EDT

NEW YORK (Reuters) - The unraveling U.S. subprime mortgage market is causing other markets to fray around the edges faster than anyone expected.

As the Federal Reserve convenes for its latest meeting on Tuesday, the corporate credit markets are grinding to a halt. About $90 billion of bonds and nearly $250 billion of loans are still awaiting buyers, several high-profile hedge funds from the U.S. East Coast to Australia have failed, and a major U.S. mortgage lender this week closed its doors.

"All these people saying there is no credit crunch and no economic impact - 'Are you kidding me?'", said Jeffrey Gundlach, chief investment officer at TCW Group in Los Angeles, which manages assets worth $160 billion.

"Ask Goldman if there is no credit crunch, ask Bear Stearns if there is no credit crunch, call up American Home Mortgage and ask them if there is no credit crunch. Come on! It is staring you in the face," Gundlach added.

On Friday, shares in Bear Stearns Cos. BSC.N dropped as much as 7.85 percent after credit rating agency Standard & Poor's lowered its outlook on the bank's debt to negative, citing problems at Bear's managed hedge funds.

In a conference call, Bear Stearns Chief Financial Officer Samuel Molinaro said: "It's as been as bad as I've seen it in 22 years. The fixed income market environment we've seen in the last eight weeks has been pretty extreme."

His comments on Friday helped cause the biggest one day fall in the benchmark S&P 500 stock index since February 27.

The volatility in global financial markets this month resulting from rising default rates on U.S. subprime mortgages has led to a risk reappraisal across credit and stock markets, which some say can be seen as good news for the Fed as it cools a takeover boom fuelled by excessive global liquidity.

Nonetheless, global financial markets have been "gripped by panic," said Chen Zhao, managing editor of Global Investment Strategy at Bank Credit Analyst in Montreal.

"Further intensification of financial stress will likely push the Fed to take action," he added.

Hit particularly hard by the drying up of liquidity and rising risk aversion are investment banks and brokerage firms which have been left to underwrite takeover deals already announced.

PAIN SPREADING BEYOND BEAR

Two Bear Stearns hedge funds collapsed last month and this week the investment bank blocked investors from withdrawing money out of a third fund as losses in the credit markets expand beyond securities related to subprime mortgages.

But Bear Stearns had some company this week.

Macquarie Bank Ltd., Australia's largest securities firm, said investors in two hedge funds may lose up to 25 percent of their money, blaming fall-out from the U.S. subprime mortgage crisis.

Boston-based hedge fund manager Sowood Capital Management LP said this week that it lost more than $1.5 billion in July after declines in the corporate debt markets and will close its two funds.

On Tuesday this week American Home Mortgage Investment Corp AHM.N, which focused on borrowers with decent credit scores, said lenders had cut off its access to credit and that it might have to liquidate its assets. By the end of the week it had closed its doors.

FED TO THE RESCUE?

"The fallout from the U.S. subprime crisis continues to inflict damage, the ensuing rout in the marketplace has been frightening, and there is growing concern over whether the crisis will widen and threaten the entire U.S. banking system's stability," said Zhao of Bank Credit Analyst.

Indeed, Corporate America has not found demand for any of its paper as bonds and loans have not been able to price, according to Greg Peters, chief U.S. credit strategist at Morgan Stanley.

The appetite for risk-taking has diminished considerably. In less than two months, risk premiums on high-yield bonds have jumped 177 basis points higher from their historic low of 241 basis points over Treasuries on June 5, according to the Merrill Lynch Master II High-Yield Index.

"The Fed historically acts quickly to ease policy whenever the banking system's ability is threatened," said Zhao.

The magnitude and scope of the ongoing subprime crisis is "serious," but Zhao said it is "not enough to jeopardize the stability of deposit-taking institutions, nor dire enough to cause a full-blown credit crunch."

Financial markets have another view: the futures markets were pricing in a 95 percent chance of a Fed interest rate cut as soon as October, up from a 16 percent probability of a rate cut just two weeks ago.

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