The unthinkable

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Traders and risk managers will be returning to their desks this month after the traditional New Year break wondering what 2008 will bring. For the first time in more than five years, the picture looks decidedly iffy.

Credit markets continue to suffer from the woes that began in the US subprime mortgage market: structured investment vehicles remain under pressure, billions of dollars of constant proportion debt obligation notes are on review for a possible downgrade, and several monolines are on the brink of losing their AAA ratings - unthinkable just months ago. At the same time, house prices in the US are falling and credit card delinquencies are on the rise, causing some to predict the possibility of an out-and-out recession.

Meanwhile, interbank lending rates remain high, reflecting reluctance by banks to lend to each other. Three-month sterling Libor hit 6.65% on December 5 - its highest level since September 18 - compared with the Bank of England's (BOE) base rate of 5.75%. A 25-basis-point cut by the BOE the following day did little to ease interbank lending rates - Libor remained between 6.6% and 6.65% until December 12 amid a strong demand for cash from banks ahead of the year end.

Three-month sterling Libor has since fallen below 6% - it fixed at 5.89% on January 2. But the past few months have indicated a worrying phenomenon: the apparent impotence of the world's central banks. Liquidity injections totalling hundreds of billions of dollars, combined with rates cuts from the US Federal Reserve and the BOE, have helped but have by no means resolved the problems. Making the situation trickier is that an ongoing concern about inflation (oil and food prices remain high) means central banks' options, and in particular their ability to cut rates further, are constrained.

In some senses, the current crisis is reminiscent of Japan in the 1990s and the early part of this decade. Stricken by a deflationary spiral, the Bank of Japan cut rates to zero in an attempt to bolster the economy. However, the country's banking sector, weighed down by trillions of yen in non-performing loans, remained comatose. With the manipulation of interest rates no longer an option, only a concerted effort to write off bad loans, combined with a huge injection of public funds, began to turn things around.

That's not to say the situation is anywhere near as serious now - for a start, investment banks have been quick to write off subprime exposures. But it does suggest the world's central banks may need to get a little more creative to help ease the crisis. The first step in this direction occurred on December 13, when five central banks announced a co-ordinated plan to hold a series of auctions to provide billions in loans and accept wider collateral from banks. It does appear to have helped ease interbank lending rates, but if the crisis continues in 2008, further creative measures may be required. The question is: what?

- Nick Sawyer, Editor.

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