European Central Bank President Jean-Claude Trichet on Monday said strong vigilance was needed, promting speculation about a rate rise in the euro zone. - Reuters

New evidence of damage wrought by the American 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 investmentvehicle (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.

British bank Barclays, hit by worries over its exposure to highly leveraged debt vehicles, holds collateral that would limit losses to £75 million (US$150.5 million) at most, a source familiar with the matter said.

Merrill Lynch, meanwhile, downgraded Bear Stearns, Citigroup, and Lehman Brothers Holdings to "neutral" from "buy" on Tuesday and lowered estimates for the banks' earnings, due to 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 euro50 billion for 91 days but with banks bidding for a total of euro119.75 billion, strong demand pushed up the cost.

"There is still a huge premium for cash particularly in the three months area," one trader said.

REAL DAMAGE

European Union officials were cautiously optimistic about the resilience of euro zone economic growth to a credit crisis but German data suggested wariness at the very least.

"Up to now we do not see any notable impact on the growth perspectives of the euro zone as a whole. But we will have to wait a few more weeks to draw up final conclusions," Luxembourg premier Jean-Claude Juncker, whochairs the monthly meetings of euro zone finance ministers, told reporters.

A survey by the GfK market research group showed German consumer sentiment was likely to worsen in September due to households' fears that market volatility may hurt the economy.

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.

BERNANKE SPEECH

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 firm expectations of a US 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. The Fed follows on September 18.

Markets reassessed after ECB 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 be re-established.

"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 recognised financial market wobbles might require further action if they 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.

- Reuters