Credit markets begin to thaw

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An unprecedented $3 trillion of cash is being pumped into the banking system worldwide - potentially one-third of it from the U.S. Treasury - and it finally started to unglue stuck credit markets Tuesday.

The massive Treasury plan to bolster the nation’s banks got near universal praise on Wall Street. Investors rushed from safe havens such as gold and Treasury bills, where they have sheltered money during the past month of market turmoil, and piled into other markets from commercial paper to municipal bonds.

Bond investors bailed out of Treasuries and dove into other credit investments in part because of a huge increase in Treasury issues needed to fund its $250 billion bank recapitalization plan - which some analysts think will help push the budget deficit and Treasury borrowing past $1 trillion this fiscal year.

“The great global banking crisis of 2008 looks over,” said Hugo Dixon, analyst with Breakingviews.com, noting that the combined effort of European nations and the United States was massive enough to make a difference in credit and money markets that trade in tens of trillions of dollars each day. “It should be big enough to restore confidence, unfreeze money markets and get banks lending to each other again.”

But the cost will be a ballooning federal budget deficit, which the White House said can be expected to rise from $455 billion in the year ended last month to $732 billion or more this year. Treasury borrowing could be even higher: The Treasury disclosed Tuesday that it already has borrowed an extra $300 billion in the past few months to fund bank rescue programs, and the obligations to fund banks will only widen this year.

In a sign of thawing, short-term bank lending rates dropped and California made headway selling $4 billion of short-term notes, although investors were demanding significantly higher interest rates that prompted Ohio, Massachusetts and other states to delay their offerings.

While the acute credit crisis may be ending, “the economic crisis is not,” Mr. Dixon said. Analysts expect the economy to experience fallout from the Wall Street crisis for months to come, including thousands of job losses, business closings and consumer retrenchment as loans remain hard to get.

Brian Bethune, chief U.S. financial economist at Global Insight, said the Treasury plan came at a critical time when many banks had reached the end of their ability to raise funds on their own and faced the prospect of insolvency and failure without such “massive” assistance.

“The Treasury secretary and the chairman of the Federal Reserve have finally declared war on the financial crisis, and this may well represent a critical turning point,” he said.

But the implications for the U.S. budget deficit and borrowing are immense, he said, predicting that the Treasury will return to Congress later this year or next to ask for more funds to aid banks. In addition, members of Congress are considering a second economic stimulus plan that could add another $300 billion to the deficit.

“It’s plausible to think we’re looking at a budget deficit of a trillion dollars a year,” C. Fred Bergsten, director of the Peterson Institute for International Economics, said at a recent forum. This would be “heretofore unforeseen territory,” he said.

Precisely because of the enormous amount of money involved, the U.S., European and Japanese measures to prop up banks provided “the level of commitment the markets have been looking for,” said Paul Lennox, corporate treasurer at Custom House, a Canadian investment firm. “Both credit and equity markets finally appear to be responding to weeks of efforts to restore calm to the markets and the banking sector.”

U.S. stocks rallied strongly on release of the Treasury plan Tuesday morning, with the Dow Jones Industrial Average gaining nearly 400 points almost immediately. But indexes pared gains later in the day, and the Dow ended with a moderate loss of 76 points.

Besides giving banks a much-needed cash boost, the Treasury plan “also sends a strong message that no other major banks will be allowed to fail,” Mr. Lennox said. “The U.S. Treasury now realizes that letting Lehman Brothers fail was a huge mistake because of the message it sent to the markets, i.e., who’s next?

“Fear and panic absolutely gripped the markets after the failure of Lehman and it has taken a monumental effort by the U.S. Treasury and central banks around the world to regain investors’ confidence.”

“Now that that confidence is being restored, we’ve probably seen the worst of this crisis,” he added, but “this does not mean that stock markets will be returning to previous highs any time soon.” Mr. Lennox predicted “a long period of debt deleveraging and the associated economic recession that goes with the bursting of a debt bubble.”

The dim outlook for debt-burdened consumers prompted Standard & Poor’s Corp. Tuesday to predict much higher default rates among corporations that cater to consumers. It said such corporate default rates could reach a stunning 23 percent in the next two years - creating more stress for the credit markets to absorb.

Executives at General Motors Corp.’s financing unit, one of the companies hit hardest by the credit crisis, said in an internal memo to company employees that it has “limited if any access” to financing, and that funding the company has become like “hand-to-hand combat,” Bloomberg News reported.

Dustin Reid, a senior currency strategist at ABN Amro Bank, said the most dire scenario for the economy has been averted, however.

“The coordinated government intervention takes the probability of a 1930s-style depression off the table,” he said.

The Treasury move prompted an uptick in optimism about prospects for the markets.

“We are closer to the end than the beginning” of the financial downturn which has pounded global markets, said Gerard Aquilina, vice chairman of Barclay’s Wealth, who is advising clients to selectively buy corporate bonds, mortgage securities and distressed real estate.

“If you are a long-term investor, this is a great buying opportunity,” he told a Reuters conference. “If one can stomach some volatility, I think that investors that have a five-year horizon will be very pleased.”

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