Financial Markets Spooked As Subprime Woes Spread to Europe

The spread of subprime loan problems to Europe triggered fresh jitters in financial markets, sending stocks sharply lower in the U.S. and Europe and sparking a rally in U.S. Treasurys as investors sought safe havens.

The problem began early Thursday after France's biggest bank, BNP Paribas, froze withdrawals from three hedge funds hit by U.S. subprime market woes. European banks, spooked by mounting credit losses. scrambled for cash, sending overnight borrowing costs in Europe to six-year highs and prompting the European Central Bank to pump $130 billion into the system to calm markets.

As investors in the U.S. awoke to news of credit problems in Europe, U.S. stock futures fell sharply. European banks were also borrowing heavily from U.S. banks, which pushed the U.S. federal funds rate up to 5.5%, a quarter point above the Federal Reserve's target of 5.25%.

The Fed then added $24 billion in funds to the banking system as part of its weekly market operations. The move, which was $9 billion more than expected, was aimed at pushing  the federal funds rate back down to 5.25%. The increased funds thus helped U.S. banks provide cash to European banks without causing any liquidity problems at U.S. banks themselves.

Rate Cut Coming?

The Fed action also fueled speculation that the central bank may cut the benchmark federal funds rate to 5% from 5.25% in September. But many analysts dismissed the speculation as wishful thinking. Just two days ago, Fed policymakers held the fed fund rates steady, saying inflation remained the primary concern rather than weakness in the economy or nervousness in the credit markets.

Still, CNBC's Steve Liesman reported that the Fed is likely to inject even more liquidity into the system on Friday.

U.S. stocks fell sharply when the market opened, but the losses were not as big as many had feared. Still, the selloff was broad-based, with all of the S&P 500 sectors trading lower.  Financial stocks, which had been the darlings of Wednesday's rally, were leading the decline.

The decline picked up speed in late trading after reports of more hedge fund problems, especially two owned by Goldman Sachs.

"I think this is the Hindenburg," said Peter Schiff, president of Euro Pacific Capital. "We've got all of this bad mortgage paper all around the world and it's going to get worse."

"What you want to find out is who has the most exposure to the credit derivative markets," said Arthur Hogan, managing director at Jefferies.  "We don't know exactly how much damage has been done and how much follow-through there will be from subprime up the credit ladder."

Meanwhile, the scramble for cash among banks forced traders to unwind so-called carry trades, where low-yielding currencies such as the Japanese yen are sold to finance purchases of higher yielding assets, such as U.S. stocks.

That sparked a broad-based yen rally, but the surge in short-term dollar deposit rates lent the dollar support against most other major currencies.

Bush: Economy Strong

In an impromptu news conference late Thursday morning, President Bush said tried to calm financial markets, saying U.S. economic fundamentals were strong despite turbulence in the housing market, thanks to low inflation, a solid job market and a strong global economy.

"The fundamentals of our economy are strong," Bush told reporters. "I'm told there is enough liquidity in the system to enable markets to correct."

The U.S. Treasury department also said it was keeping a close eye on financial market activity.

"The Treasury Department continues to monitor markets and remains vigilant," a department spokeswoman said.

Still, many investors are worried that problems in the subprime mortgage market, which are home loans to people with poor credit histories, will continue to spread. The Wall Street Journal reported Thursday that even supposedly safe money-market funds may be exposed to the subprime market.