New evidence of damage wrought by the U.S. mortgage sector surfaced in the United States and Europe on Wednesday while banks demanded a record amount of cash at a euro zone money market auction.
Cheyne Finance Plc, a structured investment vehicle (SIV) managed by British hedge fund Cheyne Capital Management, said it was seeking to restructure after being forced to start selling assets to pay down debt.
Standard & Poor's downgraded Cheyne Finance sharply. Just two weeks ago, the agency said ratings on SIVs -- including the Cheyne vehicles -- were weathering turmoil caused by defaults on U.S. subprime mortgage lending mainly to poor people.
Merrill Lynch on Tuesday downgraded Bear Stearns (BSC.N: Quote, Profile, Research) Citigroup Inc (C.N: Quote, Profile, Research) and Lehman Brothers Holdings (LEH.N: Quote, Profile, Research) to neutral from buy and lowered estimates for the banks' earnings, due to their credit and mortgage market troubles.
The only thing that is certain is that more uncertainties in the direction of asset prices and volatility are on their way, Bank Julius Baer said in a report.
Euro zone banks bid for a record amount of money at the ECB's regular long-term funding operation on Wednesday, reflecting ongoing tightness in the interbank lending market.
Central banks have poured funds into money markets to tackle a liquidity crisis, stemming from the subprime saga, which has made many banks clam up on normal interbank lending.
The European Central Bank lent out 50 billion euros for 91 days to cover banks' medium-term funding needs. With banks bidding for a total of 119.75 billion euros, strong demand pushed up the cost.
There is still a huge premium for cash particularly in the three months area, one trader said.
REAL ECONOMY DAMAGE
In terms of wider economic damage, a survey by the GfK market research group showed German consumer sentiment was likely to worsen in September due to households' concerns that market volatility may hurt the economy.
The turmoil on financial markets has obviously had quite a negative impact on consumer sentiment, even though Germans aren't as caught up in the stock market as say the British or Americans are, said Unicredit economist Alexander Koch.
In the United States, mortgage applications fell for a second consecutive week, the Mortgage Bankers Association said.
Data on Tuesday showed U.S. consumer sentiment suffered its steepest plunge in nearly two years and a house price index posted the biggest drop in its 20-year history.
Now the question is not so much where the losses are and how far the cancer has spread but how much of the business and consumer economy are affected, said Justin Urquhart Stewart of 7 Investment Management.
Consumer spending has driven growth in the world's largest economy.
CENTRAL BANKS WAIT IN WINGS
The turmoil has prompted investors to look for a rapid policy response from the major central banks.
A speech by U.S. Federal Reserve Chairman Ben Bernanke on Friday, on Housing and Monetary Policy, may harden expectations of a U.S. interest rate cut, while serious doubt has been cast on the chances of a European Central Bank rate rise next week.
The ECB hold its regular monetary meeting on September 6, and the Fed follows on September 18.
Markets scaled back their expectations for an ECB increase after President Jean-Claude Trichet stressed on Monday that his last comments on monetary policy, when he used the strong vigilance phrase signaling a rate rise was likely, were made before the market volatility began.
ECB Executive Board member Gertrude Tumpel-Gugerell said the recent turbulence showed how rapidly contagion could spread around the world but predicted calm would return.
I am confident that confidence will return, she told reporters on the sidelines of a conference in the Austrian Alps.
Minutes of the Fed's last monetary meeting -- held just before the credit squeeze prompted it to cut its discount rate for direct lending to banks -- showed it recognized financial market wobbles might require a policy response if this worsened.
A further deterioration in financial conditions could not be ruled out and, to the extent such a development could have an adverse effect on growth prospects, might require a policy response, the minutes said.