Last updated: September 15, 2008 10:23 pm

Overview: Financial markets rocked by Lehman crisis

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The dramatic collapse of Lehman Brothers, AIG’s appeal for aid and the forced sale of Merrill Lynch sent shockwaves across financial markets on Monday. The S&P 500 closed at its lowest level in nearly three years and recorded its biggest one-day fall for seven years as investors fled from risky assets.

“There is a sense today that the financial landscape has changed irrevocably,” said Peter Dixon, UK economist at Commerzbank.

Marco Annunziata, chief economist at UniCredit, said the US Treasury had taken a huge gamble by allowing Lehman to fail. “The financial system now faces the unprecedented challenge of absorbing the unwinding of a major broker,” he said.

“If it works, it should boost considerably the hopes that the global financial system can work itself out of the year-long crisis. But the risk is enormous.”

The cost of insuring corporate bonds against default shot higher and the CDR index of dealers active in the credit derivatives market rose well above the record highs of March when Bear Stearns collapsed.

Government bonds were the main beneficiaries of the flight to safety, with the Japanese yen, Swiss franc and gold also edging higher on safe-haven buying.

“There is bound to be a major reconsideration of counterparty risk at every level, adding to the multiplier effect of credit constriction,” said Alan Ruskin, strategist at RBS Greenwich Capital. “The prospective spillover from other institutions under the microscope is reasonably touted as potentially more painful than the Lehman’s wind down.”

Mr Dixon at Commerzbank said that in the near term, there were obvious fears that money market spreads would rise as institutions once more hoarded liquidity.

“Counterparty risk is very much going to be the market theme for the coming weeks,” he said.

Money market stress was apparent as the gap between the three-month interbank dollar rate and the overnight index swap rate – a gauge of the willingness of banks to lend to each other – widened to 105 basis points, the most since December. The so-called Ted spread – the difference between three-month Libor and the three-month Treasury bill yield – ballooned to more than 200 basis points as investors sought the safety of government bonds.

The yield on the three-month Treasury – widely viewed as the world’s most liquid asset – plunged 70bp. At the long end of the curve, the 30-year yield was trading at an all time low of 4.02 per cent late in New York, down 30bp.

As interest rate futures priced in high odds that the Fed would ease policy when it meets on Tuesday, the interest rate-sensitive two-year Treasury bond yield fell 51bp to 1.71 per cent – its first drop below 2 per cent, the current level of the benchmark Fed Funds rate, since April. It was the biggest one-day fall in yields since September 2001. The pronounced decline in Treasury yields sparked a big fall in US mortgage rates.

European government bonds and interest rate futures also rose sharply.

China cut interest rates by 27bp to 7.2 per cent, the first reduction in six years. Diana Choyleva, at Lombard Street Research, said: “The authorities have switched their priority from fighting inflation to supporting growth, when there is no clear evidence either that the economy’s overheating has been curbed or that there has been a marked growth slowdown.”

Credit default swaps widened steeply. The iTraxx Crossover index, an indicator of risk aversion, hit 640bp before retreating. The US CDX index rose 44bp to 195bp, near its record close of 198bp in March.

European equity markets fell to their lowest levels since mid-July, while in New York the S&P 500 closed at its lowest level since October 2005 with a fall of 4.7 per cent.

The pan-European FTSE Eurofirst 300 index fell 3.6 per cent. Markets in Japan, Hong Kong and China were closed for holidays, although those Asian markets open for business fell sharply.

The MSCI emerging markets equities index extended its recent steep declines, while Brazil’s Bovespa index plunged 7.6 per cent, its biggest one-day decline since September 2001. The spread of emerging market sovereign bonds over US Treasuries hit a fresh three-year high.

In the currency markets, the dollar recovered from an early sell-off. The yen’s biggest gains came against the high-yielding Australian and New Zealand dollars.

In commodities, US light sweet crude closed well below $100 a barrel, while gold staged a moderate rally.

Julian Jessop, at Capital Economics, said the continued decline in oil prices and the relatively lacklustre response of gold to the crisis on Wall Street underlined the view that the bull market in both was over.

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