The Fed cut rates again on Tuesday, this time by 75 basis points, bringing the rate to just 2.25 percent, the lowest since 2004. This was coupled with other extraordinary action, such as a 25 basis point cut in the discount rate, and the extension of a US$30 billion line of credit to cover investments by Bear Stearns. The calamity to befall Bear Stearns, the fifth-largest investment bank in the US, is beginning to reveal just how extensive the credit crisis is. The effect on New Zealand can be seen through higher home-loan rates here as overseas investors get nervous about lending.

The Fed took action to bail out Bear Stearns, worth an estimated US$20 billion in January 2007, after the bank suffered major liquidity problems as investors pulled out their money on rumours the company was losing millions on mortgages. JP Morgan Chase & Company purchased Bear Stearns for US$2 a share (or US$236 million in total) with the support of the Fed, which provided a US$30 billion line of credit on the likelihood of large losses on Bear Stearns investments.

While large banks have lost billions already in this implosion in the lending markets, the collapse of Bear Stearns, such a dominant player, has moved the issue well and truly centre-stage.

Rumours are flying as to how badly affected other banks may be. Lehman Brothers stocks have halved in value in the last seven weeks, while UBS stocks are down one-third. However, Lehman Brothers did report a profit for the quarter ending February 2008, according to just-released results. Although net income was half what it was in the first quarter a year ago, it was above expectations, bringing a sigh of relief and swift pre-opening rises in its stock price.

With several other finance houses due to announce earnings this week, and the depth of the crisis as yet un-plumbed, there is no way to know just how far things will go. One thing does seem certain, however. For six months of sub-prime mortgage news, mainstream banks seemed to escape relatively unscathed (if billion dollar losses can be called “relatively unscathed), but the picture has changed dramatically.

How does this affect New Zealand? Already we see home loan rates rocketing, even without the Reserve Bank’s aid. Most major banks raised rates by around 30 basis points two weeks ago on their own initiative, rather than responding to an increase by the RB. Why does this happen?

Some have (perhaps cynically) suggested that these rises may have been to prop up profits to cover losses by New Zealand-based banks on overseas investments. With rates falling in the US, they argue, it should be easy for our banks to borrow there at bargain-basement rates and pass those benefits on to home-buyers, unless they are using the rates differential to boost profits.

While this may explain in part why we are not benefiting from lower overseas rates, the rise in our rates is also likely to be linked to the difficulty our banks are having in accessing credit overseas. While exposure to the sub-prime market is not nearly as great in New Zealand as in the US for example, our banks do account for 77 percent of our net international debt. In other words, our banks are sourcing the money they lend overseas. If investors overseas are more nervous about lending to markets they know little about, or think are risky, they will charge a premium. And the banks will pass this premium on to home-buyers.