The European Central Bank’s (ECB’s) massive intervention in the money markets on Thursday - at Euro 95 billion, its biggest-ever injection of liquidity into the financial system - seemingly came out of nowhere. In the previous 48 hours, the US Fed, the Bank of England and the ECB itself had all made hawkish statements, hinting at the need to raise interest rates to tackle inflation and playing down problems in the credit markets.
What prompted the change of heart was a ballooning of spreads in the overnight Commercial Paper (CP) markets, accompanied by the evaporation in liquidity for asset-backed CP. But even that didn’t seem to reflect any particularly startling news. Rumours of liquidity problems at West LB were denied, the suspension of three Paribas funds reflected valuation problems and were small in the grand scheme of things. And while Dutch Bank NIBC reported that sub-prime losses had all but wiped out profits for the year, it still revealed healthy tier one capital of 10.5%.
As a result, the ECB’s intervention has provoked more questions than answers. In terms of its immediate objective, it clearly succeeded. Overnight yields fell back from 4.6% to the ECB’s target rate of around 4%. Without that support, money market funds would have been forced to take funding at dangerously loss-making levels.
And some so-called conduits, with exposure to US mortgage-related asset-backed securities, might not have been able to get funding at all, leading to wholesale dumping of assets, demands for emergency loans from the banks, and further suspensions. Given money market funds are used to provide instant liquidity for everyone from retail investors to firms, the risk was the credit crunch would spread to the real economy. But the scale of the intervention is worrying. The decision to offer unlimited support raises two uncomfortable possibilities. The first is that the ECB knew something the rest of the market didn’t. Was it aware of a major institution in real trouble? That would be bleak news for the markets. The other possibility is that the ECB responded to immense political pressure to help out Europe’s banks, many of which seem to have had big exposure to US sub-prime. Issuing such a get-out-of-jail-free card would certainly be short-term positive for the markets - but at the expense of storing up big problems further down the road.