Fed Fails So Far in Bid to Reassure Anxious Investors

By Serena Ng, Grep Ip, and Shefali Anand
The Wall Street Journal
Tuesday, August 21, 2007

Investors largely shrugged off the Federal Reserve’s attempt to restore order to the credit markets and bought up the safest government securities, triggering the biggest drop in yields on short-term Treasury bills in nearly 19 years.

While the stock market rose, conditions improved in currency markets and several companies successfully sold new bonds, investors refused to take any risk with their cash holdings. Instead, they accepted sharply lower yields in exchange for the safety of government bonds.

Their actions signaled that the Fed, which moved Friday to shore up confidence in the markets, has failed so far to persuade investors that problems in securities linked to subprime mortgage loans wouldn’t cause widespread losses in normally safe securities.

To ease a worsening credit crunch, the Fed on Friday cut the interest rate it charges on direct loans to banks from its “discount window” to 5.75% from 6.25% and took other steps designed to increase the flow of cash to the nation’s financial system. While the Fed didn’t alter the key federal-funds rate, its target for short-term interest rates, it said that the “downside risks to growth have increased appreciably” and it was “prepared to act.”

It made no mention of inflation, its principal concern for the past two years.

Stock and bond markets initially reacted positively to the Fed’s overture, but grew more skeptical as this week began. The reaction yesterday in the Treasury-bill market can be seen as “a vote of no confidence in the Fed’s move,” said Larry Dyer, an interest-rate strategist at HSBC Securities in New York. “If people felt that the end of the problem was around the corner, yields would be higher. But we’re still seeing a continued flight to quality, and that’s not what the Fed wanted.”

The latest wave of risk aversion in the credit markets is being led by managers of money-market funds, which are designed to behave like bank accounts and whose primary goal is to avoid losing money for investors. While some of these funds own only short-term Treasury bills, most also own corporate IOUs known as commercial paper and other highly rated, short-term securities.

Because both individual and institutional investors are worried about risks in the commercial-paper market, they have been shifting money to Treasury-only funds. That has forced funds that hold commercial paper to sell some of those holdings and Treasury-only funds to buy even more Treasury bills. Some funds that own both types of securities are shifting toward Treasurys.

Mutual-fund companies such as Vanguard Group and Fidelity Investments say they have been flooded with calls from investors asking whether their money-market funds hold commercial paper backed by mortgage securities. Vanguard said its money funds aren’t exposed to subprime-mortgage assets, and Fidelity says it has “minimal” holdings of them. Still, in many cases investors have moved their money to lower-yielding Treasury funds.

In the final three days of last week, money-market investors overall poured $50 billion into these Treasury- and government-only funds, while pulling $21 billion out of so-called prime money markets, which can invest in other securities, according to iMoneyNet Inc., which tracks money-market mutual funds.

Money-market managers themselves are worried about losing money or “breaking the buck,” a reference to the stable net asset value of these funds. Michael Cheah, a fixed-income portfolio manager at AIG SunAmerica Asset Management in Jersey City, N.J., says a colleague recently asked whether he should invest in a seven-day commercial-paper issue from a large U.S. bank. The paper bore an attractive yield of around 5.5%.

“I told him: This is all about safety. If we break the buck, we will lose our bonus and may get fired,” says Mr. Cheah, adding it would be better to invest in Treasurys. The manager decided to put the money in a short-term Treasury repurchase loan that paid 4.3%.

“This is about dealing with what we don’t know. There is little margin for error in money-market funds,” adds Mr. Cheah.

As investors snapped up three-month Treasury bills yesterday, prices soared and the yield, which moves in the opposite direction, fell for the fifth straight day, tumbling 0.7 percentage points to 3.05%, the sharpest decline since January 1989. The three-month yield sank as low as 2.5% at one point during the day. The yield on one-month Treasury bills fell 0.61 percentage points to 2.35%.

“The market is clearly saying that what the Fed has done isn’t enough. We’re having a crisis of confidence, and investors with the cash have no risk appetite at all,” said James Kauffmann, head of fixed income at ING Investment Management in Atlanta.

Still, many analysts say it is too early to measure the full effect of the Fed’s effort to improve liquidity by encouraging banks to borrow. Stocks rose yesterday as investors digested the Fed’s move. The Dow Jones Industrial Average gained 42.47 points to 13121.35, on top of Friday’s 230-point advance.

One positive sign from the credit markets is that several companies managed to sell new bonds yesterday. SABIC Innovative Plastics sold $1.5 billion in junk bonds to fund its buyout of General Electric Co.’s GE Plastics unit, agreeing to pay 9.5% interest on the debt. It was the largest junk-debt sale since a sale of loans by Chrysler Group in late July. Comcast Corp., Bank of America Corp. and Citigroup Inc. also issued new investment-grade bonds.

In addition to cutting the discount rate, the Fed also moved Friday to lengthen the term of any direct Fed loans to banks to 30 days from one day and reminded banks they could pledge a wide variety of collateral, including unimpaired subprime mortgages. Fed officials reassured bankers that they would view borrowing from the discount window as a sign of banks’ strength. Such loans have developed a stigma because they have been viewed as a last resort for troubled banks.

While banks don’t need the cash, the Fed hopes they will use it to lend to their own customers or to finance transactions in relatively safe securities, such as those backed by prime jumbo mortgages. So far, Deutsche Bank is the only bank that has said it has borrowed from the discount window, according to people familiar with the German bank.

Even so, the Fed hinted yesterday that it is expecting a sizable response by banks. It said it would redeem $5 billion of maturing Treasury bills in its portfolio to offset other factors that could expand its balance sheet, such as “discount window borrowings.” Traders took that as evidence the Fed expects about $5 billion in such borrowings in coming days. The planned move has the added benefit of freeing up more Treasury bills for the public to buy. The Treasury Department also helped by selling a larger-than-expected $32 billion in new four-week Treasury bills at its auction yesterday.

Fed officials have indicated they expect it to take some time before they know whether their actions had restored confidence to the debt markets. Some economists say the Fed may have only a few days to wait for market conditions to improve. If conditions deteriorate, it will have to take the more aggressive step of cutting its main interest rate target, the federal-funds rate, from the current 5.25%.

Stephen Stanley, chief economist at RBS Greenwich Capital, said the Fed has given the impression it would prefer not to cut rates at all, and that if it had to, it would do so at its scheduled Sept. 18 policy meeting. “But given what happened today, I’m not sure they’ll make it that far.”

While the stock market rose and trading appeared to improve in currency and some bond markets, money managers said it was still difficult to make trades in some cases. Jeff Gladstein, global head of foreign exchange trading at AIG Financial Products Corp. in Wilton, Conn., said that trading liquidity in some of the high-yielding currencies, like those for many emerging-market countries, was the worst he had seen in a few years. “There’s a repricing of risk going on,” he said.

In other currency markets, volatility declined in comparison to last week. The relative calm “doesn’t necessarily mean that nervousness is declining,” said Jens Nordvig, a currency strategist at Goldman Sachs. “There’s not much appetite to trade.” The elevated uncertainty about where money-market rates are heading is also making it more difficult to price currency forwards, which are contracts used to trade a currency at some future date. If there’s going to be abnormal volatility in prices, “You need a strong desire in order to trade at all,” said Mr. Nordvig.

The European commercial-paper market also struggled despite recent injections of capital. Yesterday, traders in London said trading was difficult; investors demanded higher yields and shorter durations. In a research note yesterday, Deutsche Bank analyst Ganesh Rajendra said, “Never before in our memory has the European structured finance market looked so fragile.”

The problems in the market caused troubles for another investment firm. London hedge fund and money manager Solent Capital Partners LLP said an affiliate might have to sell some assets, including securities tied to U.S. mortgages because it couldn’t raise the funding it needs.

Solent, which had $8.8 billion under management in mid-July, said a debt vehicle it oversees may have to sell U.S. bonds it owns because it has found few buyers for the short-term debt the vehicle uses for financing. The Solent affiliate, registered in the Cayman Islands, is called Mainsail II Ltd. It owns about $2 billion in securities underpinned by assets including U.S. mortgage loans, according to a Fitch Ratings report in May.

Mainsail II sells short-term commercial paper to cover its existing debts and to buy assets that generate returns. A Fitch Ratings report said the main focus of Mainsail II is high-grade residential mortgage-backed securities.

In the U.S., Wall Street money-market specialists said that while some issuers of commercial paper backed by mortgage assets had to exit the market, most of the maturing short-term debt was being resold, albeit some of it at higher-than-usual interest rates and for shorter terms.

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