Market meltdown: Apocalypse not now

The horror that stalked global stock exchanges as the week opened has been replaced by relief, but the threat to the world as we know it remains

Doreen Mogavero finally had time for a breather on Thursday, her first of the week. Surveying the New York Stock Exchange floor, which she has prowled for three decades, she is proud of the way her fellow traders got through one of Wall Street's wildest weeks.

"It is much quieter today – and thank goodness, because I am very tired. I'm too old for this," laughs the 52-year-old. "In markets like this you have to stay cool-headed, try to make sound decisions rather than reacting emotionally, and I think we did that despite everything swirling all around us."

It was some swirl. European and Asian markets were in free fall when Ms Mogavero got into her car in the New York borough of Staten Island after the long weekend on Tuesday morning. When she got out of the car in Manhattan's financial district, she fully expected a 600-point drop on the Dow Jones Industrial Average in the first minutes of trading, and who knows what carnage after that. But by the time she got to her booth on the exchange floor, the Federal Reserve had slashed interest rates, its biggest cut in 25 years.

It was the start of a two-day roller-coaster that included a three-hour period of trading late Wednesday when the Dow went up, bottom to top, by 600 points. As dazed traders and investors clamber off the ride, it is not clear that they are any the wiser on the main financial questions of the day: Can the bond insurance industry be saved from a collapse? Will the Fed halt a US recession? Is this a bear market?

At the Manhattan offices of Dresdner Kleinwort, the German bank, Kevin Logan had been fielding a growing number of calls about the "monoline insurers", until the start of this month a pretty obscure piece of the credit markets jigsaw but suddenly revealed as crucial to their functioning. He is Dresdner's senior US economist, the go-to guy for traders and risk managers when they need an infusion of data, economic theory and experience of how institutions and markets behave. His speech is slow, measured – Mr Logan wouldn't know how to panic – but he was offering a gloomy prognosis at the start of the week and advising traders to "reduce risk" (that's economist-speak for "SELL!").

The monoline insurers guarantee some $2.4 trillion of bonds, promising to pay out if the borrower defaults. Among those bonds are the complicated mortgage-backed derivatives that Wall Street gorged on until the credit meltdown began last August. The monolines may not have the money to cover those guarantees, and if they go under, Wall Street could have to write off tens of billions of dollars on top of the $100bn that has already been lost on these derivatives. Wall Street's banks simply can't afford that.

"They have just gone to China, Singapore, the Arab governments for billions. Can they really do that again?" Mr Logan wondered. "But they also don't have the money to bail out the insurers. I couldn't work out who would bail the insurers out, and if you can't see a solution, you advise reducing risk."

The Fed's dramatic rate cut, by reducing the cost of short-term funds for banks, was meant to make it cheaper for them to carry out their lending activities and therefor make taking on additional risk more attractive. It was also meant to shock the markets, to arrest the downward spiral that could – eventually, through scaring the corporate executives who make hiring and spending decisions – hurt the economy.

Did it work? Hard to be confident, and the bar-room and blogosphere commentary in the immediate aftermath was hardly positive. One danger is that the Fed and its chairman, Ben Bernanke, have undermined their own credibility, in effect admitting the economy is in more trouble than they predicted. Another danger is the law of diminishing returns. What would be needed to stem the next stock market panic?

The crisis could not have come at a worse time for Mr Bernanke, who was the subject of a much talked-about interview for the New York Times magazine last weekend, aimed at shoring up his credentials but which only highlighted the criticism that has rained down on him for months from credit market traders who think he has been too slow to act to prevent recession.

Having been bounced into an emergency cut, the Fed is under pressure to give an additional boost at its scheduled meeting this Wednesday. The markets are betting on another half-point cut, and will be disappointed if it is not forthcoming.

After Tuesday's rally the markets were accelerating down again by lunchtime the next day. What really triggered the rebound was news that New York state's insurance regulator had stepped forward with a plan to bail out the monolines. Eric Dinallo had been corralling Wall Street's biggest banks to stump up $15bn in a refinancing package, it was revealed. A day later, though, Mr Dinallo was quietly warning that a deal was complex and would take time. In other words, we may not have advanced far from the start of the week.

Meanwhile, the sense remains that Wall Street is contracting, a slow squeeze. Every couple of days there is news of a few hundred lay-offs at one bank or another – Bank of America and Morgan Stanley in the past week – and those that are still at their desks focus on what they can. Mortgage-related structured finance has been all but wiped out, the era of the private equity mega-deal is over for now. And meanwhile, small businesses and home buyers find conditions on new loans are just that little bit more onerous than before.

India

When the roller-coaster hit India, it came fast. On Monday the Sensex stock market index witnessed the largest absolute fall in its history, losing 4,097.51 points in a single day.

When the market began to rally on Wednesday, it had shed nearly 20 per cent of its value at its peak on 10 January. But the mystery is not so much that there was a correction, as to why it took so long to arrive.

India's markets have been dangerously over-stimulated since the euphoric last week of September – when the Sensex leapt the 17,000 barrier on the same day India's cricket team came home champions. The sudden drop shook investors. "Nobody could have anticipated the speed of the correction," says Anup Bagchi, head of retail broking at ICICI bank. "On Monday, retail investors were shell-shocked – it fell so fast that they couldn't make up their minds to buy or to sell."

That India got caught in the global rout shattered the belief that it is insulated from the rest of the world. Indian stocks kept climbing long after most other markets had faltered as its growth rests less on exports to the US, and more on its domestic economic liberalisation.

"The economy is relatively insulated, but markets may not be," says Manishi Raychaudhuri, executive director of investment research at UBS in Mumbai. "When it comes to markets, sentiment and risk aversion show through as well as company earnings."

But India's market bulls argue that the real origin of its crash lay at home. The enormous sums sucked up by the upcoming $3bn listing of Reliance Power meant there was less capital around to lend the market support when it began to fall. Reliance Power's bankers claim to have received orders of around $190bn, and as institutional investors have to deposit 10 per cent of their order, the flotation hoovered up more than $10bn of liquidity. And after the first sharp fall in stocks, retail investors, who make up 60 per cent of India's trading volume, couldn't meet margin calls on their futures contracts, so brokers were forced to sell in large numbers.

Opinions on where the market is headed diverge widely. But most banks still expect the Sensex to end the year up. "It's too early to say the panic's over," says Mr Raychaudhuri. "But the general mood is positive."

Europe

Over in Europe, the great and the good were dragged off the slopes at Davos – where they were enjoying some of the best skiing for years – to talk to their offices about the financial roller-coaster. Like their US counterparts, traders in Paris, London and Frankfurt found their screens flashing red throughout a dire five days. By far the worst was Monday's trading, when €240bn was wiped off the value of Europe's companies, with Britain's FTSE 100 collapsing by more than 5 per cent.

So much for the de-coupling theory that suggests US travails have less impact on the world these days. Europe might be uncomfortably cosy with its Atlantic cousin, but the response of the central bankers couldn't have been more different. While the Fed slashed the cost of borrowing by three-quarters of a per cent, the Bank of England Governor, Mervyn King, and European Central Bank President, Jean-Claude Trichet, showed little appetite for a similar loosening of monetary belts.

Every inch the sober economist, Mr Trichet gave few reasons to be cheerful: "There is one needle in our compass and it is price stability. There is no contradiction between price stability and financial stability."

After Monday's falls, markets across the continent yo-yoed up and down throughout the week but by Friday they had more or less recovered. The FTSE clawed back most, closing at 5869 while Germany's Dax and France's CAC indices faired less well.

Not bad news for everyone mind you – The London Stock Exchange and inter-dealer broker ICAP which thrive on trading and volatility – hinted at excellent figures due soon. But that euphoria was soon dimmed by the €4.5 bn losses of Société Gé*érale trader, Jérôme Kerviel. Can things get worse? Probably – the banks start reporting their results soon and there may be more Kerviels to be revealed.