Calm returned slowly to financial markets on Monday, but there were lingering signs that credit problems persist despite policy-makers' insistence that the global economic growth would remain solid.

The Federal Reserve on Friday cut the rate at which it lends to banks to defuse the growing crisis in credit markets and encouraged more borrowing, particularly by big banks worried about their exposure to the beleaguered U.S. mortgage market.

Deutsche Bank reportedly borrowed funds directly from the Federal Reserve on Friday, although it was unclear how much, the Financial Times reported on Monday.

However, the broader credit market seemed far from normal, particularly in the housing sector, where prices are falling and defaults are rising.

Investors' confidence in the mortgage financing space is not doing well, Larry Goldstone, chief operating officer of Thornburg Mortgage Inc, said in an interview with CNBC television on Monday.

In order to meet funding obligations, Thornburg said it has sold $20.5 billion of assets and reduced short-term borrowings by an equivalent amount.

Adding to the uncertainty among investors, Fannie Mae, the largest source for U.S. home loans, said it will skip its monthly benchmark note issuance in August for the first time since May 2006.

While stock market volatility eased from near five-year highs hit last week, U.S. stocks gave up early gains on Monday, following oil prices lower. Asian stock markets rallied while European equities chalked up modest gains.

short-term U.S. Treasury yields sank to the lowest since December 2004, reflecting high anxiety and a propensity for safety.

Things have stabilized from last week but the worst isn't over yet, said Michael Pond, Treasury strategist at Barclays Capital in New York.

TAKE SOME TIME

Away from the trading rooms of Wall Street, policy-makers around the world struck a sanguine tone about the impact of market volatility on the global economy, even after the Fed said on Friday that the risks of the U.S. economy slowing have grown appreciably.

Canadian Finance Minister Jim Flaherty told reporters on Monday that it would take some time for the turmoil in credit markets to be resolved, but that the fundamentals of Canada's economy remain strong.

Germany's Bundesbank said the outlook for the global economy remained positive despite recent market tension, which represented a welcome normalization, albeit an abrupt one.

Nevertheless, the risks for the global economy have increased with the correction process in the U.S. property market, the German central bank said in its monthly report.

STILL ON ALERT

Central banks remained on alert on Monday.

In the wake of the market turmoil, investors have sharply altered their forecasts for monetary policy. They expect the Fed, which added another $3.5 billion on Monday in short-term liquidity, to cut its key fed funds target rate and are no longer pricing in rate increases from the Bank of England.

More than half of U.S. primary dealer banks polled by Reuters predict the Federal Open Market Committee will lower the fed funds rate at its September 18 meeting, or even earlier.

The European Central Bank said it would again allot more funds than strictly necessary at its weekly tender, but aimed to reduce surplus liquidity in the short-term euro money market gradually as conditions normalize.

Australia's central bank also injected a sizable amount of liquidity into the banking system, seeking to temper upward pressure on some short-term money market rates.

But few investors are confident all the troubles stemming from the U.S. home loan market have yet seen the light of day, and they fear further market turmoil could cut growth.

Richard Shelby, a member of the U.S. Senate's Banking, Housing and Urban Affairs Committee, said banks would increase their mortgage rates in the coming weeks, exacerbating tight credit. I think it will get worse before it gets better, Shelby said in Brussels. There will be firms that will not survive. I don't think we should bail them out.

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