Federal Reserve slashes interest rates

17 March 2008

The Federal Reserve has cut interest rates in the US by 75 basis points to 2.25% in a bid to restore confidence in the financial markets.

And the Bank of East Asia has said it will cut its prime lending rate in Hong Kong by half a percentage point to 5.5%.

The moves follow stockmarkets across the world experiencing heavy losses on Monday - the aftermath of the emergency bailout of the US investment bank Bear Stearns.

The fifth-largest investment bank saw its share value fall by 46% to just $30 (£15) last Friday (14 March) after sub-prime write-downs of $3.2 billion. Rumours of a cash shortage led to a run on the bank with investors withdrawing around $17 billion.

However, JPMorgan Chase stepped up as its knight in shining armour over the weekend, buying the credit crunch-stricken bank for $2 a share. This values Bear Stearns at just $236 million (£116 million). The Federal Reserve is to fund up to $30 billion of the bank's assets in return for JPMorgan guaranteeing all its due payments.

The Federal Reserve says the 75 basis point cut in interest rates should help "promote moderate growth over time and to mitigate the risks to economic activity".

But it warns: "Recent information indicates that the outlook for economic activity has weakened further. Growth in consumer spending has slowed and labor markets have softened.

"Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters....downside risks to growth remain."

Experts were predicting a cut of at least 1%, suggesting that the Fed has confidence in the market's ability to ride out the crisis.

Impact on the UK

Although the FTSE 100 closed last night 217 points down on Monday, itmade a recovery the next morning and eventually closed up 3.54% at5,605 points. Similar rises were seen across Europe on Tuesday with theDax in Frankfurt rising by 1.8%, and in Paris the Cac was up 1.9%. InNew York the Dow Jones is climbing again up 21 points at 11972.3.

Bear Stearns' collapse could have an impact on the finances of many Brits, not just investors.

Some experts are pointing fingers at other investment banks, warning they could be the next names to hit the headlines with further sub-prime write-downs and liquidity issues.

Simon Denham, managing director at Capital Spreads, warns that the survival of other investment banks are fragile in the current nervous climate.

He said: “Speculation will now focus on the other weak investment banks. Mere rumour was enough to ruin it for Bear Stearns as deposit holders rushed to extract their funds - now we actually have a factual failure. Who is going to risk being a deposit holder in the next domino to fall?

“In this scenario we could see the destruction of several institutions over a very short period of time and the eventual rise of just a few “super” entities.”

As banks suffer the after-effects of the credit crunch, they continue to take steps to recoup their losses. Unsurprisingly, mortgages are one area nearly all banks have cracked down on – partly because lax lending in the US is one of the main causes of the current market turmoil but also because a slowing housing market means this sector doesn’t look as attractive as it did a year ago.

Banks are no longer willing to lend money to just anybody – in fact, the criteria they look at to determine your borrowing risk has tightened significantly. This means that if your credit profile is not squeaky clean you may find it hard to get a mortgage or loan at an attractive rate.

Secondly, lenders are also expecting borrowers to put more of their own money into a property. Nationwide will no longer offer its most attractive mortgage rates to borrowers unless then have at least a 25% deposit to put down. And 125% mortgages, which lend over the value of the property, are no longer offered by lenders despite their popularity among first-time buyers last year.

Finally, mortgage rates have increased and are likely to continue to do so. Interbank interest rates – known as LIBOR – have been creeping up for some time and now stand at 5.84%, meaning it is increasingly expensive for banks to borrow credit to fund their lending activities.

Angela Knight, chief executive of the British Bankers’ Association, said the continued rise of LIBOR rates reflects increasing liquidity pressures in funding markets internationally.

It's not just mortgage borrowers who are suffering. Some credit card customers have already seen their credit limits slashed, and providers such as Egg have withdrawn cards from customers they deem high risk.

However, one silver lining could be for savers. Banks are keen to increase their customer deposits and may therefore increase their rates in order to entice more savers through their doors.

The Bank of England might also be forced to react to the turmoil, cutting interest rates when it next meets in April. This could ease pressure for banks and bring mortgage rates down.

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